By Steven A. Melnyk & R.T. "Chris" Christensen

In this month's column, we complete our overview of ABC analysis. We also show how ABC analysis can be adjusted to consider costs. For the next six months, you can expect the following topics to be covered in this column:

• What are we? We deal with the question of how management determines whether its firm is project, job shop, repetitive or continuous. This is an important issue and frequently encountered when managers use the various surveys produced by this magazine. Within these surveys, the software vendors identify the appropriateness of their packages (i.e., whether they are appropriate for job shops, assembly line and process). Some managers have encountered problems in identifying what type of firm they are.
• When are cost savings not cost savings? In this article, we will look at the name of cost savings. We show that some are true cost savings, while others pertain only to opportunity cost savings.
• Developing an understanding of lead times under various settings and conditions. We will use four articles to come to grips with this very elusive concept.

In these last articles, we will see the contributions of Randall Schaefer.


Doing the ABC analysis — The answer
The first item of business is that of providing the answer to the problem assignment from last month. Well, here it is.

SKU	Unit Cost	Annual Usage	Total Annual	%	Rank	ABC Class
1	0.05	50,000	$2,500	38.6	2	A
2	0.11	2,000	$220	3.4	5	B
3	0.16	400	$64	1.0	7	C
4	0.08	700	$56	0.9	9	C
5	0.07	800	$336	5.2	4	B
6	0.15	1,300	$195	3.0	6	B
7	0.15	17,000	$2,250	39.4	1	A
8	0.20	300	$60	0.9	8	C
9	0.09	5,000	$450	6.9	3	B
10	0.12	400	$48	0.7	10	C
			$6479

Other factors
In this case, we see that there are two As, four Bs and four Cs. Is this the end of it? Not really. The analysis that we have done is based strictly on numerical or quantitative analysis. Ignored are such factors as:

• Lead time (the longer the lead time, the more closely that we have to monitor the item. Thus a C item might become either a B or A item).
• Volatility of design/engineering changes (the more frequent the changes, the more closely the item must be monitored because of the threat of obsolete inventory).
• Storage/special requirements (the more extensive the storage requirements, the more likely it is that we will have to monitor the item more closely).
• Perishability (the shorter the shelf life of the item, the more closely it will have to be monitored).

As a result, any of these factors (to name a few) could cause an item to go from being a C to being either a B or an A class item.


Introducing costs
To this point, we have focused only on the demand side of inventory. What has been ignored is that of costs. When dealing with ABC analysis, the major cost is that of the storage space occupied by the items. This is, in reality, an opportunity cost. The space that each item occupies could be used to store other — more valuable — items, or it could be used for production. One method of assigning this cost is to examine the space occupied by each item and the cost per square foot (this number can be frequently obtained from accounting). Multiplying the two together yields the cost of physically storing that item in inventory. We next take this number and subtract it from its annual dollar usage. The result is a number that can be either positive or negative. If positive, the number tells us that the annual usage exceeds the costs of storage. If negative, we know that the annual storage costs are greater than the annual usage. So what? Well, if the resulting number is negative, then we are faced with an item that costs us more to store than its usage justifies. In such cases, we might explore either dropping the item or having our suppliers (if possible) take responsibility for managing it. In any case, we have identified a candidate for eliminating or rethinking.


Lessons learned
This article has been fairly focused, in that we have dealt with the following lessons:

• We have learned how to carry out an ABC analysis.
• We have learned that the ultimate category reflects both the quantitative and qualitative considerations.
• We have shown that by including costs of storage into the analysis, through the assignment of costs for floor space, we can identify candidates for elimination, rethinking, (i.e., redesign) or assignment to a vendor for control.

Next month, we look at identifying the category to which a firm can assign itself (i.e., job shop, project, repetitive or continuous/flow).

Copyright © 2020 by APICS — The Educational Society for Resource Management. All rights reserved.

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