Inventory management - JIT and ABC analysis

Learning Outcomes

After reading this article, you will be able to explain the objectives of inventory management, describe the features of Just-in-Time (JIT) inventory systems and ABC analysis, and discuss their application in improving efficiency and controlling costs. You will also be able to compare inventory management methods and assess their practical implications for working capital and financial management.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand how efficient inventory management supports working capital objectives and business profitability. In preparation for the FM exam, focus your revision on:

• The objectives and costs associated with inventory management
• Inventory management systems, with particular reference to Just-in-Time (JIT) techniques
• The application and interpretation of ABC inventory analysis
• Methods to optimise the balance between inventory holding costs and stockout risks
• Analysis of the impact of inventory management practices on liquidity, profitability, and working capital investment

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. State two risks of holding excessive inventory and two risks associated with holding insufficient inventory.
2. In Just-in-Time (JIT) inventory systems, what is the primary focus for managing stock levels?
3. What principle underpins ABC inventory analysis?
4. True or false? Under JIT, maintaining high buffer stocks is a key objective for the business.

Introduction

Inventory is a key part of working capital management. Poor control ties up cash, while running out of stock can halt production and lose sales. Financial managers must determine how much inventory to keep, when to order, and which items are most important to manage closely.

This article introduces the main principles of inventory control, then focuses on two widely-used approaches tested in ACCA FM: Just-in-Time (JIT) inventory management and ABC analysis. Both seek to optimise inventory levels, but each uses a different philosophy and practical method.

Key Term: inventory management
Managing all aspects of stock to achieve an optimal balance between holding costs and operational needs, reducing overall costs while preventing stockouts.

The Inventory Balancing Act

Inventory managers face a constant trade-off. Holding too much inventory increases storage, financing, and obsolescence costs. Holding too little risks stockouts, halted production, and lost sales.

Key Term: stockout
A situation where demand cannot be met due to insufficient inventory on hand, often resulting in lost sales or disrupted production.

To manage this balance, different methods have been developed to help companies order, receive, and store inventory in the most cost-effective way.

Costs of Inventory

The main costs associated with inventory are:

• Holding costs: Storage, insurance, depreciation, opportunity cost of capital.
• Ordering or setup costs: Administrative expenses, transport, and handling costs for each re-order or production setup.
• Stockout costs: Lost sales, production downtime, emergency purchases at premium prices.

The right inventory system minimises the sum of these costs while maintaining business continuity.

Just-in-Time (JIT) Inventory Management

The JIT approach seeks to keep inventory levels as low as possible. Instead of holding large stocks, materials and goods are received only when needed for immediate use in production or to meet customer orders.

Key Term: Just-in-Time (JIT)
An inventory system designed to minimise internal stockholding by arranging for materials and products to arrive only as they are needed.

Key Features of JIT:

• No or minimal buffer stocks are maintained.
• Supplies are delivered frequently and in small quantities.
• Production runs are closely linked to actual customer requirements.
• Quality and reliability of suppliers become critical.
• The focus moves from forecasting and planning to flexible, demand-led processes.

Worked Example 1.1

A manufacturer using JIT receives daily deliveries of parts directly to the production line, keeping only enough supplies for the day’s work. A delay in delivery by the supplier causes a temporary halt in production. What is the key risk, and how does JIT address it?

Answer:
The main risk is a stockout due to supply chain disruption, which under JIT will halt production as there are no buffer inventories. JIT addresses this by developing close, reliable relationships with suppliers to ensure timely and consistent deliveries. Suppliers are often located nearby, and contracts stress quality and delivery performance.

Benefits and Challenges of JIT

Benefits:

• Lower inventory holding costs
• Reduced space requirement and lower working capital needs
• Increased responsiveness to customer demand
• Less risk of obsolete stock

Challenges:

• Heavy dependence on supplier reliability and quality
• Greater risk of production stoppages if deliveries are late
• Not always suitable for unpredictable or highly variable demand
• Transition to JIT may require significant investment in process and supplier development

Key Term: buffer inventory
A minimum level of stock held as a safety net against uncertainty in demand or supply.

ABC Inventory Analysis

Not all inventory items require the same level of management attention. ABC analysis splits inventory into three categories based on their monetary value to the business.

Key Term: ABC analysis
A technique that classifies inventory into three groups (A, B, C) according to their value and usage, allowing focused management where it matters most.

• A items: High-value, typically low-quantity items that account for most of the inventory cost. These require tight control and frequent review.
• B items: Moderate value and quantity; monitored with balanced effort.
• C items: Low-value, often high-quantity items that make up most inventory lines but a small part of inventory cost. These can be managed with simpler, less intensive methods.

Key Term: Pareto principle (80/20 rule)
The rule that roughly 80% of effects come from 20% of causes; in inventory, a minority of items (A items) are responsible for the majority of inventory value.

Worked Example 1.2

A company has 1,000 inventory lines. The top 100 items represent 75% of the total inventory value, the next 200 items account for 15%, and the remaining 700 constitute just 10%. Under ABC analysis, how should these categories be managed?

Answer:
The top 100 items are A items and need frequent reviews, tight security, and formal re-order procedures. The next 200 B items require moderate control and review. The 700 C items can be controlled using simple rules and bulk orders, as their impact on the total value is small.

Using ABC Analysis

ABC analysis helps prioritise management effort:

• More resources are devoted to managing A items (e.g. frequent counting, strong access controls, tight reorder levels).
• B items are reviewed regularly but less intensively.
• C items are ordered in larger quantities and with minimal administrative effort.

ABC can be updated regularly, especially as new products are introduced or demand patterns shift.

Revision Tip

Prioritise your inventory management exam revision on understanding how JIT and ABC analysis reduce costs and risk through different mechanisms. Be ready to explain the trade-offs of each approach.

Comparing JIT and ABC Analysis

Exam Warning

Do not confuse JIT, which targets minimal inventory for all items, with ABC analysis, where high-value items get most attention but others may still be held in larger stock levels. The exam may test your ability to distinguish the focus and practical use of each method.

Summary

JIT inventory systems aim to eliminate excess stock by synchronising delivery and use, requiring dependable suppliers and strong process coordination. ABC analysis ensures that management effort is put where it matters most, focusing attention on costly items and using simpler methods for the rest. Both methods aim to optimise costs and reduce risks associated with inventory, but select the most appropriate approach based on business context and demand patterns.

Key Point Checklist

This article has covered the following key knowledge points:

• The main objectives and costs involved in inventory management
• The principles, features, and risks of Just-in-Time (JIT) inventory systems
• How ABC analysis classifies stock items and shapes management priorities
• The differences between JIT and ABC in practice and exam scenarios
• How improved inventory control supports working capital objectives and profitability

Key Terms and Concepts

• inventory management
• stockout
• Just-in-Time (JIT)
• buffer inventory
• ABC analysis
• Pareto principle (80/20 rule)