Now, you can think of inventory and classify it based on the reasons that organizations keep inventory. Now keep in mind that this classification is not something that you can directly apply to a piece of inventory that you might see. You might not be able to say that this piece of inventory is pipeline or cycle, or anticipation. These are reasons on the basis of which you can classify inventory. Pipeline inventory is the time that inventory is in transit in any process. You order from a supplier that's distant from you during the time that it's in the pipeline to get to you, it's pipeline inventory. Cycle inventory is based on batch sizes. Let's say I run a batch of 10,000 units of one type of product, product X before I move to product Y? That cycle, when I'm making those 10,000 units, is going to start from zero and build up all the way to 10,000 units and I'll have 10,000 units of inventory before I send it off to the next task or to my customer, and that's going to be my cycle inventory. I'm building up that inventory during that production cycle. Anticipation inventory is something that we referred to earlier. You are overproducing when you do have the time or you're overproducing in anticipation of demand that you're expecting in the future. Then safety stock inventory is inventory that you hold for any kind of uncertainty. It might be uncertainty to do with production rates. It might be uncertainty to do with demand. It might be uncertainty to do with lead times. It may take five days for this product to get to me, or it might take eight days. I have to keep some buffer in order to allow for that uncertainty. That's what is classified as safety stock inventory. These are the main reasons that organizations keep inventory. Now here's a classification that you can actually point out and say, this inventory is raw material inventory or work in process inventory or finished goods. In any organization, you'll be able to say raw material inventory is whatever has been purchased from outside. Whatever has been purchased from an external party is going to be raw material inventory. The work in process inventory is inventory that is being worked on. Whether it's waiting to be worked on within the process boundaries, or whether it's actually being worked on in the process. Whether it's in the machine, whether it's bread that's being baked in the oven, or it's in a machine that requires a certain amount of time for something to get cured. It's going to be work-in-process inventory. Finally, finished goods inventory is anything that's ready from that organization's perspective, that's ready to go to the customer to get delivered to the customer. It's at the loading dock waiting to get on that truck to go to the customer, that's going to be your finished goods inventory. Now that we have this classification of inventory, what I'd like you to do is apply this classification to two simple kinds of businesses. The first business is a bakery, and the second business is in the same stream of products. It's a grocery store or a sandwich shop. It's a sandwich shop that uses the bread to make sandwiches. You have a bakery and a sandwich shop. What I'd like you to think about is, what are the raw materials? What is the work in process that would be the case for the bakery or the sandwich shop. Finally, what are the finished goods that these two types of businesses would have? Give that a minute and think about it, and then we'll come back and talk about the implications of this classification for these two different types of businesses. We were classifying the raw materials, the work in process, and the finished goods for bakeries and sandwich shops. For a bakery, you may have thought of flour, you may have thought of water, yeast. Those are the things that go into making bread. Those would be raw materials that they would be purchasing from outside, that they would be acquiring from outside. The work in process is going to be anything that's kept, that is in the process. If it's baking for a certain amount of time, it's working process inventory. If it's dough that's kept to mature before they start baking the bread from it, that's going to be work-in-process inventory. Finally, the finished goods are going to be the loaves of bread that come out, that get on the truck to get delivered to customers. Raw material, work in process and finished goods for a bakery. For a sandwich shop, their raw material would include the bread that they're going to buy from that bakery. The raw material for them is going to be the finished goods for the bakery. Then they're work in process inventory is going to be some of the probably the sliced bread that they keep or they might be able to do some processing of sandwiches and keep them ready for customers. Then the finished goods are going to be the ready sandwiches that are being delivered to customers. What you can see from here is that what is one organization's finished goods is going to be raw materials from a different organization's perspective. Even though we have this classification, it'll be based on the usage and the position of that organization in this whole chain that is making products for the ultimate customer. When we think about inventory, we normally think about manufacturing businesses. We say, well, in services, you can't hold inventory. It's something that you make for a customer and you cannot really keep that in stock. We think about capacity of the service as being the inventory that we hold. But if you think about it, even services such as hospitals, restaurants, and hotels have to keep inventory. They have to keep inventory of different things that are needed for them to do their business correctly. Hospitals need drugs, they need surgical instruments. Restaurants need different things to serve their food. They need different things to manufacture their food. Hotels are going to need different things that they need to stock in the rooms. They're going to need different linens to be able to use them in the different rooms. Even their inventory is going to be important and to give you an interesting fact about inventory in services. In healthcare, inventory costs can be up to 40 percent of the total operating cost. The cost of holding, and using inventory is about 40 percent of total cost. This cost, by the way, is second only to labor costs, which is obviously not surprisingly, the highest proportion of cost for a healthcare business. Inventory is pretty important even for services. Now let's look at a different way of classifying inventory. This is based on which items in inventory need more attention versus which items need less attention. This is called an ABC analysis. It's based on what you may be familiar with as the 80/20 rule. You have 20 percent of your items that account for 80 percent of the value. That's the idea between the ABC analysis is that you want to focus on those really important A items in terms of controlling the inventory, you want to keep a close eye on them. Then the C items, you may not follow as closely. You may not care as much about them in terms of keeping a close eye on them, and spending your resources keeping a close eye on them. The idea is simple. You have 20 percent of your items are responsible for 60 percent of the dollar value. The next 30 percent of the items are responsible for 30 percent of your monetary value. Then the next 50 percent of the items are responsible for the top 10 percent of your dollar value. You have the A, B, and C that is telling you which are the more important items to keep an eye on. Let's take this ABC classification, and apply it to an example. Here's an example of a company that is making automobile parts and we have data on their annual unit sales that you're going to see in the next couple of slides. They want help in identifying the A, B, and C items. Here you have the numbers to do the ABC analysis for local plane automotive parts. What you can see is the first column is just the identifier, the second column gives you the annual sales in units, and the third column is giving you the unit price. Take a minute, digest this information, and think about how you would go about converting this into an ABC analysis telling you which items you should be focusing on, spending more time on in terms of inventory control, which item's next, in terms of an ABC analysis. Here you see the result of this analysis. We've run through the numbers here. What we've simply done is converted the annual sales quantities into annual sales monetary values here, dollars, and we see that we have annual sales, a total of 169,000. Once you have that, you can convert into percentage of total sales. That's what we've done. In the next column we have the percentage of sales. What you can see right from there is item Number 2, which is responsible for 80 percent of the monetary value of the sales. That would be obviously an item to focus on. It's one out of seven items that is responsible for 80 percent of their sales and that's going to be the prime item to focus on. This analysis can give you a sense of which items to focus on next, and which items to focus on the least. As a result, what you can see is you have this classification of one out of seven products accounting for 80 percent of the sales. That one item that we saw earlier, the next in line, the next in sequence in terms of percentage of dollar value are two items that account for 50 percent of the total monetary value of sales. Then out of the total of seven items, the last four account for only five percent of the total value of sales. What we've seen from this is that you can classify inventory based on many different ways. ABC classification is one of them which focuses on the importance of inventory management for different items in inventory. Earlier we saw a classification of raw material work in process and finished goods. Then earlier than that we saw why do different companies store inventory, and we saw classification based on that.
