An inventory system controls the level of inventory by determining how much to order (the level of replenishment), and when to order. There are two basic types of inventory systems: a continuous (or fixed-order-quantity) system and a periodic (or fixed-time-period) system. In a continuous system, an order is placed for the same constant amount whenever the inventory on hand decreases to a certain level, whereas in a periodic system, an order is placed for a variable amount after specific regular intervals.
In a continuous inventory system (also referred to as a perpetual system and a fixed-order-quantity system), a continual record of the inventory level for every item is maintained. Whenever the inventory on hand decreases to a predetermined level, referred to as the reorder point, a new order is placed to replenish the stock of inventory. The order that is placed is for a fixed amount that minimizes the total inventory costs. This amount, called the economic order quantity, is discussed in greater detail later.
A positive feature of a continuous system is that the inventory level is continuously monitored, so management always knows the inventory status. This is advantageous for critical items such as replacement parts or raw materials and supplies. However, maintaining a continual record of the amount of inventory on hand can also be costly.
A simple example of a continuous inventory system is a ledger-style checkbook that many of us use on a daily basis. Our checkbook comes with 300 checks; after the 200th check has been used (and there are 100 left), there is an order form for a new batch of checks. This form, when turned in at the bank, initiates an order for a new batch of 300 checks. Many office inventory systems use reorder cards that are placed within stacks of stationery or at the bottom of a case of pens or paper clips to signal when a new order should be placed. If you look behind the items on a hanging rack in a Kmart store, there will be a card indicating it is time to place an order for the item for an amount indicated on the card.
A more sophisticated example of a continuous inventory system is the computerized checkout system with a laser scanner used by many supermarkets and retail stores. The laser scanner reads the universal product code (UPC), or bar code, from the product package; the transaction is instantly recorded, and the inventory level updated. Such a system is not only quick and accurate, it also provides management with continuously updated information on the status of inventory levels. Many manufacturing companies' suppliers and distributors also use bar code systems and handheld laser scanners to inventory materials, supplies, equipment, in-process parts, and finished goods.
In a periodic inventory system (also referred to as a fixed-time-period system or a periodic review system), the inventory on hand is counted at specific time intervals; for example, every week or at the end of each month. After the inventory in stock is determined, an order is placed for an amount that will bring inventory back up to a desired level. In this system the inventory level is not monitored at all during the time interval between orders, so it has the advantage of little or no required record keeping. The disadvantage is less direct control. This typically results in larger inventory levels for a periodic inventory system than in a continuous system to guard against unexpected stockouts early in the fixed period. Such a system also requires that a new order quantity be determined each time a periodic order is made.
An example of a periodic inventory system is a college or university bookstore. Textbooks are normally ordered according to a periodic system, wherein a count of textbooks in stock (for every course) is made after the first few weeks of a semester or quarter. An order for new textbooks for the next semester is then made according to estimated course enrollments for the next term (i.e., demand) and the amount remaining in stock. Smaller retail stores, drugstores, grocery stores, and offices sometimes use periodic systems--the stock level is checked every week or month, often by a vendor, to see how much should be ordered.
The ABC system classifies inventory according to its dollar value to the firm. Typically thousands of independent demand items are held in inventory by a company, especially in manufacturing, but a small percentage is of such a high dollar value to warrant close inventory control. In general, about 5 to 15 percent of all inventory items account for 70 to 80 percent of the total dollar value of inventory. These are classified as A, or Class A, items. B items represent approximately 30 percent of total inventory units but only about 15 percent of total inventory dollar value. C items generally account for 50 to 60 percent of all inventory units but represent only 5 to 10 percent of total dollar value. For example, a discount store such as Wal-Mart normally stocks only a few television sets, a somewhat larger number of bicycles or sets of sheets, and hundreds of boxes of soap powder, bottles of shampoo, and AA batteries.
In ABC analysis each class of inventory requires different levels of inventory control--the higher the value of the inventory, the tighter the control. Class A items should experience tight inventory control; B and C require more relaxed (perhaps minimal) attention.
The first step in ABC analysis is to classify all inventory items as either A, B, or C. Each item is assigned a dollar value, which is computed by multiplying the dollar cost of one unit by the annual demand for that item. All items are then ranked according to their annual dollar value, with, for example, the top 10 percent classified as A items, the next 30 percent, as B items, and the last 60 percent, as C items. These classifications will not be exact, but they have been found to be close to the actual occurrence in firms with remarkable frequency.
The next step is to determine the level of inventory control for each classification. Class A items require tight inventory control because they represent such a large percentage of the total dollar value of inventory. These inventory levels should be as low as possible, and safety stocks minimized. This requires accurate demand forecasts and detailed record keeping. The appropriate inventory control system and inventory modeling procedure to determine order quantity should be applied. In addition, close attention should be given to purchasing policies and procedures if the inventory items are acquired from outside the firm. B and C items require less stringent inventory control. Since carrying costs are usually lower for C items, higher inventory levels can sometimes be maintained with larger safety stocks. It may not be necessary to control C items beyond simple observation. In general, A items frequently require a continuous control system, where the inventory level is continuously monitored; a periodic review system with less monitoring will suffice for C items.
The maintenance department for a small manufacturing firm has responsibility for maintaining an inventory of spare parts for the machinery it services. The parts inventory, unit cost, and annual usage are as follows:
The department manager wants to classify the inventory parts according to the ABC system to determine which stocks of parts should most closely be monitored.
First rank the items according to their total value and also compute each item's percentage of total value and quantity.
Based on simple observation, it appears that the first three items form a group with the highest value, the next three items form a second group, and the last four items constitute a group. Thus, the ABC classification for these items is as follows:
POM for Windows has a program for performing ABC classifications within its inventory module. The solution screen for the ABC classification in Example 12.1 is shown in Exhibit 12.1. Notice that this classification scheme is not the same as the one developed in Example 12.1, which can occur frequently in ABC classification since determination of the breakpoints between the three classification groups is often judgmental and based on observation.
Excel OM, the Excel spreadsheet add-in program we have used elsewhere in this text, also has a macro for ABC classification within its set of inventory macros.
12-6. Identify the two basic decisions addressed by inventory management and discuss why the responses to these decisions differ for continuous and periodic inventory systems.
12-7. Explain the ABC inventory classification system and indicate its advantages.