ABC Analysis and Inventory Optimization

inventory optimization

The goal of effective inventory management is to “meet or exceed your customers’ expectations of product availability with the amount of each item that will maximize your net profits.”  But do all of the items you stock contribute equally to achieving this goal?  Ask yourself:

  • Do we stock products that other firms also offer and that must be competitively priced?
  • Are there products that are slow moving but might be required by one of our customers in the case of an emergency and therefore are not “price sensitive”?
  • Which products contribute the most profit dollars to our bottom line?
  • Do some products have a higher “turnover” potential than other items?

ABC analysis or “product ranking” classifies your inventory by various measurements of contribution or activity.  This process can guide you to set policies that will optimize your inventory performance.  The foundation of ranking is the “80-20” rule, also known as Pareto’s principle.  In the late 1890’s Italian economist Vilfredo Pareto found that 80% of the income in the country was earned by 20% of the people.  This rule was soon applied to business where analysts found that in many companies 20% of stocked items generated 80% of sales.

These fast moving products are typically referred to as “A” ranked products.  Because of their high sales volume they are typically available from other companies and must be competitively priced.  But the high volume of sales also creates the potential for increased inventory turnover.  That means more opportunities to earn profits from every dollar in your average inventory investment.  Even though you make less on each transaction, the high volume may result in significant profit dollars!

How do you identity the fast moving “A” items?  Start by sorting all the products in a warehouse in descending order by annual cost of goods sold, number of transactions or profit dollars (we discuss the value of ranking by each of these criteria in the whitepaper “Multiple Product Rankings – The Key to Inventory Optimization”).  In the following example we are ranking by cost of goods sold (COGS).  The total COGS for all of the products is $13,190:

Item

Annual Cost of Goods Sold

Accumulated COGS

Accumulated Percentage

Rank

A100

$3234

$3234

24.5%

A

C320

$3198

$6432

48.8%

A

B123

$2613

$9045

68.6%

A

A145

$1365

$10,410

78.9%

A

D432

$965

$11,375

86.2%

B

C542

$821

$12,196

92.5%

B

B256

$632

$12,828

97.3%

C

A734

$233

$13,061

99.0%

C

B523

$109

$13,170

99.8%

C

C452

$20

$13,190

100%

C

Total

$13,190

The “Accumulated COGS” column provides a running total of the cost of goods sold through that line item.  For example, the first three items total $9,045 or 68.6% of the total.  Notice that:

  • Items with a cumulative percentage of up to 80% are assigned a rank of “A”
  • Items with a cumulative percentage between 80% and 95% are assigned a rank of “B”
  • The remaining items with a cumulative percentage between 95% and 100% assigned a rank of “C”

The parameters of “A” rank = up to 80% of activity, “B” rank = 80% – 95% of activity and “C” rank = 95% – 100% of activity are most often used but they can be modified to meet your company’s specific needs.  But beware!  Your sales activity may not correspond with income distribution in Italy in 1897.  In the example above 4 items or 40% of the total account for 80% of total cost of goods sold and are assigned to the “A” ranking.   Don’t automatically assign a certain percentage of products to each rank; assign ranking by each product’s contribution to total annual cost of goods sold, transactions or profitability.

We’ve discussed the competitive characteristics of the faster moving “A” ranked products.  But you can you optimize the profitability and performance of the lower ranked “B” and “C” items?  These products don’t have the sales volume of the “A” ranked products.  In most cases not as many competitors will stock them and customers tend not to be as “price sensitive”.  After all, they are not frequently purchased.  In most cases these products can command a higher profit margin.  You may think you are “cheating” your customers by charging them a higher price.  But remember that these products don’t turnover as quickly as the “A” ranked products.  They are usually in your warehouse for an extended period of time resulting in a higher inventory carrying cost.  You need a higher profit margin to ensure that these products are profitable.  Most companies have a higher gross margin for “B” ranked products and the highest gross margin for “C” ranked items.

Each item you stock has a profit potential.  Ranking your products provides a valuable tool for optimizing the performance of your overall inventory investment.

Related Posts: