ABC Analysis: Limitations Of Inventory Control

Great Essays
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
…show more content…
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
…show more content…
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

Related Documents

  • Decent Essays

    Some of the challenges as given by Ronald S Tibben-Lemke and Dale Rogers are given below: 1. Forecasting for returns is difficult due to nature of uncertainty as it initiates from customers. Rates of returns are unpredictable. 2. Transportation routes are from many points to one point as the collection been done from multiple points and flow moving towards a single or few destinations.…

    • 763 Words
    • 4 Pages
    Decent Essays
  • Improved Essays

    Two of the most prominent financial-market anomalies are momentum and reversal. Momentum is the tendency of assets with good (bad) recent performance to continue over performing (underperforming) in the near future. Reversal concerns predictability based on a longer performance history: assets that performed well (poorly) over a long period tend to subsequently underperform (over perform). Closely related to reversal is the value effect, whereby the ratio of an asset’s price relative to book value is negatively related to subsequent performance. Momentum and reversal are viewed as anomalies because they are hard to explain within the standard asset-pricing paradigm with rational agents and frictionless markets.…

    • 751 Words
    • 4 Pages
    Improved Essays
  • Improved Essays

    Price fluctuation: discounts and promotion prices in forward buying may cause distortion. Rationing and shortage gaming: suppliers usually resort to rationing, which in turn provides incentives to buyers to inflate orders. Further, supply chain lacks coordination if each stage optimizes only its local objectives. Accordign to Rao (2015), “Bullwhip effect reduces the profit of a supply chain by making it more expensive to provide a given level of product availability”. It can be effect by increasing costs for the supply chain by indicators listed bellow, which will be end with…

    • 1072 Words
    • 5 Pages
    Improved Essays
  • Improved Essays

    Fmcg Case Study

    • 784 Words
    • 4 Pages

    Although given the short lead time in FMCG supply chain, it is necessary to maintain a level of safety stock, too much inventory holding calls for storage space and imposes additional costs (construction, rent, and maintenance of a warehouse, workforce, insurance, etc.). Furthermore, companies are faced with time-specific issues (namely product degradation, deterioration or obsoleteness) as well as customer-specific ones (e.g. shift in consumer demand) [5]. Most importantly, by converting cash to tangible assets too soon, they might fail to produce higher (or even) equal value. Nevertheless, in today’s competitive and volatile marketplace, it is undesirable to run out on products and lose sales [5].…

    • 784 Words
    • 4 Pages
    Improved Essays
  • Improved Essays

    Takes into account both the timing and the magnitude of cash flows. Disadvantages of NPV: It is uneasy to estimate the discount rate for a long-term period. NPV cannot handle a negative amount in the cash flow other than the initial…

    • 873 Words
    • 4 Pages
    Improved Essays
  • Improved Essays

    Discounted Cash Flow

    • 732 Words
    • 3 Pages

    This method is dynamic in its nature, also whose using this method need to be more careful. The DCF model is not much suitable for short term investing because it’s can’t predict an accreted value. It might be correct in long term investments. This method really based on with assumptions for cash flow, risks and values. The output completely related with the assumptions we choose.…

    • 732 Words
    • 3 Pages
    Improved Essays
  • Decent Essays

    The third formalised the Paris Agreement might exist inherent risk and considered as a low-level in the sales and collection cycle. The management might be underestimating the fossil fuels usage for reducing cost on the emission. Therefore, the control risk will consider high in this situation because the company have the ability to control their usage of fossil fuels and expect to future replacement of using fossil fuels. Thus, the planned detection risk will consider have a high level which based on the audit risk model (Arens et al. 2013, p.234).…

    • 896 Words
    • 4 Pages
    Decent Essays
  • Improved Essays

    The demand for these utilities is inelastic. The concept of elasticity of demand helps the government to rationalize prices for these important utilities. In the other case, prices would be unstable and unfair, if private companies sold these…

    • 733 Words
    • 3 Pages
    Improved Essays
  • Improved Essays

    BACK-FLUSH ACCOUNTING Costing systems have been augmented to reflect the manufacturing philosophy that is based on the need to achieve competitive advantage. According to modern manufacturing philosophy, flexibility is important to provide the customers with their wants at an exact time whenever it is required so as to achieve competitive advantage. This defines Just-In-Time (JIT) system whose objective is to produce or procure products or components as to when it is needed. Backflush Accounting (BA) otherwise known as backflush costing is defined as a more simplified costing system for allocating costs between stocks and cost of goods sold. To put it simply, BA is a system that delays recording some or all of the journal entries relating…

    • 1106 Words
    • 5 Pages
    Improved Essays
  • Improved Essays

    Much of managerial accounting is directed at gathering useful information about costs for planning and control decisions. 2. Direct materials are not usually easily traced to a product. 3. A variable cost changes in proportion to changes in the volume in activity.…

    • 4172 Words
    • 17 Pages
    Improved Essays