ABC Classification / Analysis of Inventory

The ABC classification process is an analysis of a range of objects, such as finished products ,items lying
in inventory or customers into three categories. It's a system of categorization, with similarities to Pareto
analysis, and the method usually categorizes inventory into three classes with each class having a different
management control associated :

A - outstandingly important; B - of average importance; C - relatively unimportant as a basis for a control

scheme. Each category can and sometimes should be handled in a different way, with more attention
being devoted to category A, less to B, and still less to C.

Popularly known as the "80/20" rule ABC concept is applied to inventory management as a rule-of-
thumb. It says that about 80% of the Rupee value, consumption wise, of an inventory remains in about
20% of the items.

This rule , in general , applies well and is frequently used by inventory managers to put their efforts where
greatest benefits , in terms of cost reduction as well as maintaining a smooth availability of stock, are
attained.

The ABC concept is derived from the Pareto's 80/20 rule curve. It is also known as the 80-20 concept.
Here, Rupee / Dollar value of each individual inventory item is calculated on annual consumption basis.

Thus, applied in the context of inventory, it's a determination of the relative ratios between the number of
items and the currency value of the items purchased / consumed on a repetitive basis :

10-20% of the items ('A' class) account for 70-80% of the consumption
the next 15-25% ('B' class) account for 10-20% of the consumption and

the balance 65-75% ('C' class) account for 5-10% of the consumption

'A' class items are closely monitored because of the value involved (70-80% !).

High value (A), Low value (C) , intermediary value (B)

20% of the items account for 80% of total inventory consumption value (Qty consumed X unit rate)

Specific items on which efforts can be concentrated profitably

Provides a sound basis on which to allocate funds and time

A,B & C , all have a purchasing / storage policy - "A", most critically reviewed , "B" little less
while "C" still less with greater results.

ABC Analysis is the basis for material management processes and helps define how stock is managed. It
can form the basis of various activity including leading plans on alternative stocking arrangements
(consignment stock), reorder calculations and can help determine at what intervals inventory checks are
carried out (for example A class items may be required to be checked more frequently than c class stores

Inventory Control Application: The ABC classification system is to grouping items according to annual
issue value, (in terms of money), in an attempt to identify the small number of items that will account for
most of the issue value and that are the most important ones to control for effective inventory
management. The emphasis is on putting effort where it will have the most effect.

All the items of inventories are put in three categories, as below :

A Items : These Items are seen to be of high Rupee consumption volume. "A" items usually include 10-
20% of all inventory items, and account for 50-60% of the total Rupee consumption volume.

B Items : "B" items are those that are 30-40% of all inventory items, and account for 30-40% of the total
Rupee consumption volume of the inventory. These are important, but not critical, and don't pose sourcing
difficulties.

C Items : "C" items account for 40-50% of all inventory items, but only 5-10% of the total

Rupee consumption volume. Characteristically, these are standard, low-cost and readily available items.
ABC classifications allow the inventory manager to assign priorities for inventory control. Strict control
needs to be kept on A and B items, with preferably low safety stock level. Taking a lenient view, the C
class items can be maintained with looser control and with high safety stock level. The ABC concept puts
emphasis on the fact that every item of inventory is critical and has the potential of affecting, adversely,
production, or sales to a customer or operations. The categorization helps in better control on A and B
items.

In addition to other management procedures, ABC classifications can be used to design cycle counting
schemes. For example, A items may be counted 3 times per year, B items 1 to 2 times, and C items only
once, or not at all.
Inflation
Factors of Inflation
Inflation is defined as the rate (%) at which the general price level of goods and services is rising,
causing purchasing power to fall. This is different from a rise and fall in the price of a particular good or
service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or
preferences and changing costs. So if the cost of one item, say a particular model car, increases because
demand for it is high, this is not considered inflation. Inflation occurs when most prices are rising by
some degree across the whole economy. This is caused by four possible factors, each of which is related
to basic economic principles of changes in supply and demand:
1. Increase in the money supply.
2. Decrease in the demand for money.
3. Decrease in the aggregate supply of goods and services.
4. Increase in the aggregate demand for goods and services.

In this look at what inflation is and how it works, we will ignore the effects of money supply on inflation
and concentrate specifically on the effects of aggregate supply and demand: cost-push and demand-pull
inflation.

Cost-Push Inflation
Aggregate supply is the total volume of goods and services produced by an economy at a given price
level. When there is a decrease in the aggregate supply of goods and services stemming from an increase
in the cost of production, we have cost-push inflation. Cost-push inflation basically means that prices
have been "pushed up" by increases in costs of any of the four factors of production (labor, capital, land or
entrepreneurship) when companies are already running at full production capacity. With higher production
costs and productivity maximized, companies cannot maintain profit margins by producing the same
amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise
in the general price level (inflation).

Production Costs

To understand better their effect on inflation, let's take a look into how and why production costs can
change. A company may need to increases wages if laborers demand higher salaries (due to increasing
prices and thus cost of living) or if labor becomes more specialized. If the cost of labor, a factor of
production, increases, the company has to allocate more resources to pay for the creation of its goods or
services. To continue to maintain (or increase) profit margins, the company passes the increased costs of
production on to the consumer, making retail prices higher. Along with increasing sales, increasing prices
is a way for companies to constantly increase their bottom lines and essentially grow. Another factor that
can cause increases in production costs is a rise in the price of raw materials. This could occur because of
scarcity of raw materials, an increase in the cost of labor and/or an increase in the cost of importing raw
materials and labor (if the they are overseas), which is caused by a depreciation in their home currency.
The government may also increase taxes to cover higher fuel and energy costs, forcing companies to
allocate more resources to paying taxes.

Putting It Together

To visualize how cost-push inflation works, we can use a simple price-quantity graph showing what
happens to shifts in aggregate supply. The graph below shows the level of output that can be achieved at
each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 (given
production is at full capacity), causing an increase in the price level from P1 to P2. The rationale behind
this increase is that, for companies to maintain (or increase) profit margins, they will need to raise the
retail price paid by consumers, thereby causing inflation.

Demand-Pull Inflation
Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four
sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four
sectors concurrently want to purchase more output than the economy can produce, they compete to
purchase limited amounts of goods and services. Buyers in essence "bid prices up", again, causing
inflation. This excessive demand, also referred to as "too much money chasing too few goods", usually
occurs in an expanding economy.

Factors Pulling Prices Up

The increase in aggregate demand that causes demand-pull inflation can be the result of various economic
dynamics. For example, an increase in government purchases can increase aggregate demand, thus pulling
up prices. Another factor can be the depreciation of local exchange rates, which raises the price of imports
and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the
buying of exports by foreigners increases, thereby raising the overall level of aggregate demand (we are
assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the
economy). Rapid overseas growth can also ignite an increase in demand as more exports are consumed by
foreigners. Finally, if government reduces taxes, households are left with more disposable income in their
pockets. This in turn leads to increased consumer spending, thus increasing aggregate demand and
eventually causing demand-pull inflation. The results of reduced taxes can lead also to growing consumer
confidence in the local economy, which further increases aggregate demand.

Putting It Together

Demand-pull inflation is a product of an increase in aggregate demand that is faster than the
corresponding increase in aggregate supply. When aggregate demand increases without a change in
aggregate supply, the quantity supplied' will increase (given production is not at full capacity). Looking
again at the price-quantity graph, we can see the relationship between aggregate supply and demand. If
aggregate demand increases from AD1 to AD2, in the short run, this will not change (shift) aggregate
supply, but cause a change in the quantity supplied as represented by a movement along the AS curve. The
rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to
changes in economic conditions than aggregate supply.

As companies increase production due to increased demand, the cost to produce each additional output
increases, as represented by the change from P1 to P2. The rationale behind this change is that companies
would need to pay workers more money (e.g. overtime) and/or invest in additional equipment to keep up
with demand, thereby increasing the cost of production. Just like cost-push inflation, demand-pull
inflation can occur as companies, to maintain profit levels, pass on the higher cost of production to
consumers' prices.

Conclusion
Inflation is not simply a matter of rising prices. There are endemic and perhaps diverse reasons at the root
of inflation. Cost-push inflation is a result of decreased aggregate supply as well as increased costs of
production, itself a result of different factors. The increase in aggregate supply causing demand-pull
inflation can be the result of many factors, including increases in government spending and depreciation
of the local exchange rate. If an economy identifies what type of inflation is occurring (cost-push or
demand-pull), then the economy may be better able to rectify (if necessary) rising prices and the loss of
purchasing power.