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What is it?

ABC analysis helps set inventory management systems and processes based on the consumption value of stocked items. However, it takes no account of consumption volatility. So two items with similarly high consumption values but very different patterns of demand may be subject to the same inventory management policies and process, which may not be appropriate. For example:

• Item 1001 costs $10,000 and demand is reliable at two per month throughout the year.
• Item 1002 costs $1,000 and demand is sporadic but typically 240 are drawn off each year.

Using ABC analysis, their consumption values would be identical ($240,000) and may be classed as A items. It may be that item 1002 is typically drawn off twice per year, but it is impossible to predict when during the year they will be drawn down.

The policies for A items in the company may be as follows:

Policy	Implication item 1001	Implication item 1002
Automatically order annual demand / 12 each month.	Low or negligible buffer. Take off equals reorder quantity. Facility costs low (low buffer).	Stock levels will build up during periods of no demand, tying up working capital. Item condition may deteriorate while languishing in inventory. High facility costs (buffer level varies).
Perpetual stock count	Cost-benefit makes perpetual count worthwhile.	Perpetual counting of stock that’s not needed is wasteful.

On the other hand, applying XYZ analysis alone ignores consumption value, which in this example is identical. Item 1001 may be classified as an X item and item 1002 may be classified as a Z item. Policy may be that X item replenishment is fully automated and Z items are manually replenished only on customer order.

Policy	Implication item 1001	Implication item 1002
Perpetual stock count	The cost-benefit makes perpetual count worthwhile.	Policy is pointless since there won’t be any stock for most of the year.
Goods receiving	Receipted to inventory.	Receipted to production or logistics.
Facilities/security	Located in inventory. Security limits losses.	Transient. So the facilities cost implication is negligible. Value not considered. So opportunity for losses are greater.

By combining ABC with XYZ approaches, stock management policies, systems and procedures can be better tailored by taking into account both demand volatility and consumption value.

A	B	C
X	AX Class High consumption value. Even demand. Reliable forecasts.	BX Class Medium consumption value. Even demand. Reliable forecasts.	CX Class Low consumption value. Even demand. Reliable forecasts.
Y	AY Class High consumption value. Predictably variable demand. Less reliable forecasts.	BY Class Medium consumption value. Predictably variable demand. Less reliable forecasts.	CY Class Low consumption value. Predictably variable demand. Less reliable forecasts.
Z	AZ Class High consumption value. Sporadic, variable demand. Forecasting unreliable or impossible.	BZ Class Medium consumption value. Sporadic, variable demand. Forecasting unreliable or impossible.	CZ Class Low consumption value. Sporadic, variable demand. Forecasting unreliable or impossible.

Accurate forecasts are of great potential benefit to a business. At one extreme, a company could “play it safe” with its forecast demand by maintaining high inventory buffer levels to eliminate stock outs. The costs avoided, or benefits reaped are:

• Eliminating the need for emergency replenishment. Emergency stock replenishment is usually costly due to, for example, not buying the economic order quantity, off-contract buying, rush penalties and additional transportation costs.
• Avoiding production disruption, which leads to lower capacity use, increased standby time and disruption to shifts – driving overtime costs up.
• Avoiding loss of customer loyalty due to missed delivery commitments or longer lead times.
• Avoiding reputation impairment, leading to erosion of market share.

On the other hand, holding costs will go up as:

• More storage space will be needed to carry the higher buffer levels.
• More people will be required to manage the stock.
• More equipment will be needed to maintain, move, count and secure the stock.
• Insurance costs could be higher as the value at risk of loss is higher.
• There is a cost of capital tied up in unproductive working capital.

So, the management accountant needs to balance the costs associated with stock outs with the costs of holding higher levels of stock. The sales manager will push for plentiful stocks to maximise customer satisfaction and loyalty, and to beat competitors on lead times. The production manager will want to minimise production disruption caused by stock outs. The CFO will want to reduce working capital and associated holding costs. There’s also the cost of replenishment to consider – the more frequently replenishment occurs, the higher the costs of replenishment. Replenishment costs include:

• The procurement function: the more orders that need to be placed, the more people are needed to do the ordering.
• The goods receiving function: people, facilities and equipment are required to receive deliveries of goods. The higher the number of orders, the more frequent goods deliveries will be – requiring more people, facilities and equipment.
• Transportation: transportation costs for frequent small deliveries usually exceed those for larger, less frequent deliveries.

In having an appreciation of all these factors, the management accountant can then work with key stakeholders (CFO, production management, inventory management, logistics, procurement) to agree inventory management policies and to develop systems and processes to implement them. Policies may include, for example:

• Degree of automation of replenishment processes.
• Buffer stocks.
• Inventory control.

To illustrate by way of example:

A	B	C
X	AX Class Automated replenishment. Low buffer – JIT or consignment transfers the responsibility for security of supply. Perpetual inventory.	BX Class Automated replenishment. Low buffer – safety first. Periodic count; medium security.	CX Class Automated replenishment. Low buffer – safety first. Free stock or periodic estimation by inspection or weighing; low security.
Y	AY Class Automated with manual intervention. Low buffer – accept stock out risk. Perpetual inventory.	BY Class Automated with manual intervention. Manually adjust buffer for seasonality. Periodic count; medium security.	CY Class Automated replenishment. High buffer – safety first. Free stock or periodic estimation by inspection or weighing; low security.
Z	AZ Class Buy to order. No buffer – customer understands lead times. Not stocked.	BZ Class Buy to order. No buffer – customer understands lead times. Not stocked.	CZ Class Automated replenishment. High buffer – safety first. Free stock or periodic estimation by inspection or weighing; low security.

What benefits does the approach provide?

• Provides a scientific and transparent framework for developing and refining stock management policies.
• Optimises tensions between the costs, risks and benefits of stock holding.
• Stakeholder focused – the needs of all key stakeholders can be factored into policy.

Implementing ABC/XYZ inventory management? Questions to consider

• Is there reliable and accessible cost and demand information by item?
• Will your inventory management systems and processes facilitate efficient and effective implementation and operation of the ABC/XYZ approach?
• Have the costs and benefits of implementing and operating ABC/XYZ been quantified and is the business case compelling?
• Has the impact of the change to ABC/XYZ on capability been assessed and planned for?

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Actions to take / Dos	Actions to avoid / Don'ts
Define the scope – which items will and won’t be included? Define the relevant time period in which to calculate demand volatility. Check to ensure that systems and processes can be adapted to ABC/XYZ before embarking on the change. Base the business case on data that’s reliable. Be realistic about the resource and time demands required for implementation. Create a robust business case with a compelling cost-benefit analysis and SMART targets. Plan for measuring and reporting on the cost-benefit.	Don’t try to classify new items unless demand volatility can be accurately predicted.
Related and similar practices to consider
XYZ, FSN and VED analysis. Perpetual inventory control. Just-in-time (JIT). Economic order quantity (EOQ).

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Production, which involves making or acquiring goods and services that the business sells, accretes costs of the directly attributable materials and processes needed in the production process. As well as these direct costs, the rest of the business’s costs (indirect costs like depreciation and administration) need to be recovered in product and service prices for it to be profitable.

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Production is an essential, if not the most essential, part of the value generation processes. The nature of competitive markets is that businesses try to increase prices, but competition compels them to be competitive on prices. This is relevant because a business’s suppliers will tend to exert upward pressure on prices but the producer will be under pressure to compete on the prices of its products. However, the producer will strive to charge their customers the highest possible prices to increase profitability, perhaps by generating unique value for their customers. So the management accountant must collaborate across the business’s supply chain (from suppliers, through production, to customers) to generate maximum value. Fundamentally, this means driving and holding costs down across the supply chain and selecting initiatives that contribute best to maximising price.