ABC Analysis: Limitations Of Inventory Control

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In management of inventories, the firm’s objective should be in consonance with the wealth maximization principle. To achieve this, the firm should determine the optimum level of investment in inventory. To deal with the problems of inventory management effectively, it becomes necessary to be conversant with the different techniques of inventory control.

Although the concepts involved in inventory management are production oriented and not strictly financial, it is important that financial manager understands them, since they have certain built-in financial costs. The different tools of inventory control are:

1. A.B.C Analysis

2. EOQ (Economic Order Quantity)

3. VED Analysis

4. GOLF Classification

5. XYZ Analysis

6. SDE Classification
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Concentrating on all the items is likely to have a diffused effect on all the items, irrespective of the priorities.

Limitations of ABC Analysis:

ABC analysis, in order to be fully effective, should be carried out with standardization and codification. ABC analysis is based on grading the items according to the importance of performance of an item that is by V.E.D -Vital, essential and Desirable— analysis discussed later.

Some items, though negligible in monetary value, may be vital for running the plant, and constant attention is needed. If the inventory position is analyzed according to the value, commonly known as XYZ analysis, then results of ABC and XYZ analysis will be different, depending upon the nature of obsolete items.

The results of ABC analysis have to be reviewed periodically and updated. It is a common experience that a ‘C’ item, like diesel oil in a firm, will become the most high value item during power crisis. However, ABC analysis is a powerful approach in the direction of cost reduction as it helps to control items with a selective approach.
2. Economic Order Quantity
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S = Cost of placing an order.

I = Inventory carrying costs of one unit.

Limitations of EOQ Model:

1. The demand for inventory is seldom constant. When demand fluctuates, the EOQ model will give misleading results. In a period of rising demand, EOQ model based on historic demand levels will suggest smaller inventory levels that are economical.

2. The lead time for any supplier is generally unpredictable. Therefore, buffer stocks are required to ensure against changes in lead time. It is difficult to determine buffer stock as it depends upon uncertainty in the lead time.

3. It is very difficult to determine carrying cost. Only a rough estimate can be made of obsolescence and deterioration costs.

4. The EOQ formula is based on the assumption that no stock-outs will take place. In some cases, an occasional stock-out position may be less costly than carrying excessively large stocks. But it is not easy to determine the cost of stock-out.
3. VED Analysis:

In this analysis, the items are classified on the basis of their criticality to the production process or other services. In the VED classification of materials:

V = Vital items

E = Essential items

D = Desirable

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