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With the growing need for customization of products, many manufacturers have diversi-fied their product lines. For instance, milk products can be categorized into several dif-ferent stock-keeping units (SKUs) such as whole milk, 2% low-fat milk, zero-fat milk, lactose-free milk, chocolate flavor milk, and so forth. Such product proliferation can overwhelm the task of managing all SKUs with equal attention. Therefore, priorities should be set to handle inventories. One of the systematic ways of classifying inventories with respect to their priorities includes a classic Pareto principle, where approximately 10% to 20% of the inventory accounts for approximately 60% to 80% of the total inventory value, or 80% of the sales volume is typically accounted for by 20%

of the products (customers). This principle originated from the Pareto principle, named

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Chapter 5: Inventory Control and Planning 131

after a nineteenth-century Italian economist Villefredo Pareto , who discovered that a

“vital few” (about 20% of the population) controlled a vast majority (80%) of the wealth in Milan, Italy. The Pareto principle, based on the observation that many situations were dominated by a very few elements, was broadened to classify inventory into several dif-ferent categories with respect to their priorities. The most popular inventory classifica-tion schemes include critical value analysis and ABC inventory analysis, which will be discussed in detail in the following subsections.

Critical Value Analysis

Critical value analysis is frequently used by military organizations, which “subjectively”

classify inventory items by assigning point values for three to five categories. The man-ner in which inventories are classified by critical value analysis is summarized in Table 5.1. Examples of the top-priority items might include ammunition and rifles, whose shortages can jeopardize solders’ lives. Examples of high-priority items might include military vehicles such as Humvees and armored vehicles, whose shortages can under-mine the soldiers’ fighting capability. Examples of medium-priority items might include military tents and shovels whose shortages would not create life-threatening situations for soldiers but are needed for their comfort. Examples of low-priority items might include military uniforms, shirts, and underwear, which are not essential for combat readiness.

Table 5.1. An Inventory Classification Made by Critical Value Analysis

Category Item Features

1. Top priority No stockout—critical items

2. High priority Essential, but limited stockouts permitted 3. Medium priority Necessary, but occasional stockouts permitted 4. Low priority Desirable, but stockouts allowed

ABC Inventory Analysis

ABC inventory analysis classifies inventory items or SKUs into three categories—“A”

items, “B” items, and “C” items—according to the total annual dollar usage. ABC inven-tory analysis was initially developed in 1951 by H. Ford Dicky of General Electric to categorize inventory items into three classes according to relative sales volume, cash flows, lead time, or stockout costs. Potential criteria for the ABC classification scheme include the following:

• Annual dollar volume of the transactions for an item

• Unit cost (price)

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• Scarcity of materials used in producing an item

• Availability of resources (e.g., manpower, facilities) to produce an item

• Lead time

• Storage requirements (e.g., refrigeration) for an item

• Pilferage/shrinkage risk, shelf life

• Cost of running out of stock

• Engineering design volatility

A rule of thumb for illustrating the ABC classification scheme is shown in Table 5.2.

Table 5.2. An Illustration of the ABC Classification Scheme

Question Classification

1. Annual usage > $50,000 2. Unit cost (price) > $500 3. Lead time > 6 months 4. Shelf life < 3 months

A

1. $10,000 ≤ annual usage ≤ $50,000 2. $100 ≤ unit cost ≤ $500

3. 3 months ≤ lead time ≤ 6 months 4. 3 months ≤ shelf life ≤ 6 months

B

1. Annual usage < $10,000 2. Unit cost < $100 3. Lead time < 3 months 4. Shelf life > 6 months

C

Figure 5.2 graphically depicts the results of ABC classification scheme. Table 5.3a summarizes the degree of control and planning associated with the ABC inventory clas-sification scheme. Table 5.3b provides specific guidelines for managing different types of inventories (A Comprehensive Guide on Materials and Supply Chain Management, 2007).

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Chapter 5: Inventory Control and Planning 133 Percentage of Items

Figure 5.2. The graphical display of the ABC classification scheme

Table 5.3a. ABC Inventory Control and Planning

Item Degree of Control Type of Records Lot Size Frequency of Review Size of Safety Stocks

A Tight Accurate and

complete

Small Continuous (frequent) Small

B Moderate Good Medium Occasional Moderate

C Loose Simple Large Infrequent Large

Table 5.3b. ABC Inventory Management Guidelines

Item Management Responsibility

Purchasing Strategy Potential Sources of Supply

Frequency of Deliveries

Follow-ups

A Senior manager Centralized purchasing

Multiple Weekly Frequent

B Middle level manager Either centralized or decentralized

Double or more Every three months Periodic

C Delegated to a floor-level employee or inventory clerk

Decentralized purchasing

Single or double Every six months Occasional

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134 Chapter 5: Inventory Control and Planning

Because a shortage or unavailability of higher-dollar usage or fast-moving items can have a greater adverse impact on the customer service level, different customer service strategies should be developed in accordance with the ABC classification, as illustrated in Table 5.4.

Table 5.4. Customer Service Strategies in the ABC Classification Scheme

Item Percent of Sales (1)

Customer Service Level (2)

Weighted Customer Service Level (3) = (1) × ⁽²⁾

Management Strategy

A 70% 99% 69.3% • Frequent evaluation of forecasts

• Frequent (at least once a month) cycle counting

• Daily updates of records

• Frequent review of order quantities

• Small orders

• Frequent follow-up

B 20% 95% 19% • Quarterly cycle counting

• Medium size orders

C 10% 90% 9%

Total: 97.3%

• Periodic review or visual replenish-ment (two bin system)

• Large order quantities

• Count items infrequently