ABC Inventory: Get the Most Out of Your Best-Selling Products
Over a hundred years ago a man with a brilliantly complicated name stumbled upon a brilliantly simple principle.
Italian engineer Vilfredo Federico Damaso Pareto came to realize there was a pattern so common in the universe that it has been applied across a range of disciplines since.
It is now evolved and known in inventory management as ABC Inventory.
ABC Inventory is an approach to managing inventory that attempts to prioritize sets of stock by the amount of value they bring to the business.
Basically, it assumes that some stock is more valuable than others — which means that you should spend more resources in tracking “strong” stock and reducing the amount of “weak” stock.
So, provided you have a business which has varying product values this method can help reduce your carrying costs.
It’s a perfectly logical system which relies on the pattern which Mr. Pareto came up with, and the great thing is that you can do your own analysis with just a pen and paper.
We’ll get to how we do it later, but first...
What is ABC Inventory Control?
Increasing efficiency isn’t just about your manufacturing processes. It’s about making sure you spend your time and money on the right products - that’s where ABC inventory comes in.
The story says that Mr. Pareto was strolling through his beloved garden when he noticed his pea pod patch.
Unfortunately, many of them were unhealthy and when he thought about it, he realized that only 20% of them produced 80% of the healthy pods.
Drawing on this observation on distribution, he discovered that in Italy, during that time, 80% of the land was owned by 20% of the population. Which, of course, meant that most of the land was owned by the few.
100 years on and that same principle seemed to apply to the world’s GDP. In 1979 it was found that 80% of the wealth in the world was owned by 20% of the people.
Of course, this is not a natural law of the universe, but the funny thing is that this principle has been found to apply to a whole bunch of fields.
Here are some of the commonly noted areas:
- 20% of computer bugs cause 80% of crashes;
- 20% of customers make 80% of profits;
- 20% of staff produce 80% of results; and
- 20% of patients create 80% of healthcare expenditure
The point here is to show that many things in life are not distributed evenly; and understanding that some things are more valuable than others means you can focus your energy in the right places.
If you fix the 20% of bugs which cause the most issues first, then you can make a quick effective impact.
If you focus on the 20% of patients, then you can come up with solutions that save money in future.
And the same things apply to inventory.
Except in this case it’s called ABC inventory control.
What’s awesome is that the same magic applies to inventory management as it does to all those other examples.
Honestly, it’s one of the things that once you accept and understand can change your entire mindset in business decision making.
Because once you appreciate which bits of your inventory are the most important, you can focus your energy there to get the most out of it.
In the same way you see which inventory is just hanging around and gathering dust, you can do what you should have done a long time ago and stop overloading your inventory with dead weight.
You can cut down on your carrying and storage costs.
You can make sure that your inventory stock ratio is kept at an effectively high level.
Provided you are careful with your categorizations, the difference ABC can make to optimizing your inventory is not to be underestimated.
Dividing into ABC Inventory
Not all stock was created equal. ABC inventory should quickly help you realize that. Just be careful you don’t get too hung up on the numbers, take the results in context.
Despite often being known as the 80/20 rule, ABC analysis in inventory management is not so cut and dry.
In fact, ABC analysis divides an organization’s on-hand inventory into three classes based upon:
1. Item A
These are the items that generally generate the most amount of sales but also constitute the smallest set of stock.
They are items that require frequent reorders due to always requiring good stock levels and should be made priority to avoid stockouts.
They are given highest security priority in warehouses and stockrooms.
2. Item B
These are items that generate a middle amount of sales and profits, whilst constituting a slightly bigger set of stock than item As.
Items here are checked occasionally to see if they should be moved for inclusion into sections A or C.
3. Item C
These are the items of which there are many but sell very few. This means that the low demand leaves them hanging around in inventory for long stretches of time.
It is best to set a low reorder point for these and allow them to sell out before remanufacturing them.
What should be monitored with these, is whether they should have production continued depending on if they are being sold enough.
Often, it’s best to just make these make-to-order products - that way you only start making the product after an order has come in.
And that’s how the items are divided in the ABC method of inventory. You can see that each classification has its own place.
Remember that keeping track of the divisions is important, because products can change in demand.
Don’t just leave them to it.
ABC Inventory Classification
Okay, so understanding the divisions conceptually is one thing. But how do we know which items go into which category?
Well before going into it we need to split our items into classifications that have sensible distributions. The following are what many manufacturers would consider but remember that they are a rule of thumb.
You should also consider that it depends on your business model, as well the number of item types of you stock.
But here are the lines to start with:
Item A - Top 15% represent 70% of sales
Item B - Middle 20% represent 20% of sales
Item C - Bottom 65% represent 10% of sales
This graph demonstrates the general classifications for ABC inventory analysis. Note that item A creates 70% of total sales whilst only constituting 15% of the items in inventory.
How Do You Calculate ABC Inventory?
Now for the deep dive.
Hold your nose and take a deep breath.
First things first, let’s look at an example inventory for a leather goods business and work out which items would be in which classification.
To start we got the columns beside each item which show the annual demand as well as the cost per unit.
This is going to be the starting point for your calculations.
After that you want to multiply the demand and cost so that you can get the annual cost for each item. And then you want to add up all of them so you can get a total cost for the whole inventory.
So here you see the value that each item brings, as well as the total of all of them – 19,475 dollars.
Now, you can divide each annual cost of an item by the total annual cost of all items. This will give a percentage figure which gives an idea on how valuable the items are individually.
And once that has been done, you can sort them from largest to smallest to get a clean overview.
With this information we can see right in front of us, which products have the most and least usage value.
This is where the magic happens.
Apply the general rule of thumb for ABC inventory management as mentioned before:
Item A - Top 15% represent 70% of sales
Item B - Middle 20% represent 20% of sales
Item C - Bottom 65% represent 10% of sales
Starting with item A, we are looking for around the top 15% of products to bring 70% of sales.
In this case we can see that backpacks alone only bring around 50% of total annual cost.
But once you also add belts into the mix, then we can see that we have just over 70% of sales.
There we have it, backpacks and belts are designated as item A.
Obviously, this doesn’t have to be precise, and the values in this example are quite crude, but you will be surprised to find how often this pattern works.
So anyway, now we can look to see what item Bs are going to be.
Adding up collars, flasks and handbags takes us to just over 17%.
We could add journals to get to 20% of sales but there is a clear distinction between the annual cost of journals and phone cases.
It makes sense to draw the line there.
And everything below that line, as the weakest of our stock, is going to be classified as item C.
Here is the final picture for clarity:
You can do the exact same process yourself with a simple spreadsheet.
Just note that the purpose here is to distinguish items from each other in terms of their usage value. Don’t worry about the numbers matching up exactly.
Think about the purpose of this exercise in classifying your products effectively.
How ABC Analysis is Useful in Inventory Management
Now you’ve gone and done your calculations.
How do you realize the importance of ABC inventory analysis?
Here are some of the awesome ways you can take full advantage:
Optimize inventory – you can make sure that you are well-stocked on A items and have low stock on C items, and ABC gives you a plan of action for it;
Improved pricing – sorting your products by demand means calculating selling price accurately potentially raising profits;
Set appropriate safety nets – this kind of analysis allows you to understand at what point a product is in its life, so you can determine the correct safety stock levels;
Prioritize products – items in the A category can have more attention and resources allocated to them, allowing better strategic decisions;
Targeted customer service – you can now make sure that your highest value customers get extra attention.
Track materials efficiently - you can manage your raw materials efficiently by having a greater grasp on your finished products.
PRO TIP: Incorporate your classifications into your SKU system.
That way everyone in the business can immediately see which products should be given priority.
How ABC Analysis is Done for Customers
The cool thing about ABC inventory is that the same principles can be applied across your business. One of those is for grouping your customers into the ones that bring the most and least value to your business. It’s a great way to start rewarding your loyal customers by paying extra attention.
By now it shouldn’t come across as a surprise that you can use this method in more places that just ABC inventory.
The same methods of ABC analysis can be applied to your customer base.
You might be asking: what’s the point in that?
Well the benefits are many-fold.
For one, by knowing which customers are most valuable you can allocate greater attention to them - both in terms of support and giving them more of that they want.
But even more importantly is that having three classifications in front of you means that you can make strategic decisions with what otherwise would be complex sets of data.
For example, if you came to find most of your A customers were millennials then you could adjust your marketing strategy accordingly.
Or you can prioritize orders in your Smart Manufacturing Software to make sure that your A customers get their deliveries on time in times of high demand.
PRO TIP: Don’t use a Smart Manufacturing Software, yet?
Try Katana for free and scale your business today!
The only thing is that performing this kind of analysis well is a little more complicated than ABC inventory.
As well as profits the customers bring, you want to try and investigate:
On top of these you can add anything else that could give a more accurate overview of the value your customers bring.
Once you have the details in front of you though, there will little doubt as to the potential boosts it can offer your business.
Getting the Most Out of ABC Inventory
It’s funny that an Italian engineer from the 19th century came up with a principle that is helping set manufacturers up for success to this today.
A strategy which simplifies complicated sets of data and gives you a perspective with which you can strategize across your business.
That’s from inventory to customers to computer bugs.
But to really get the most out of your ABC analysis of inventory, you are going to need the tools to back you up.
Because understanding is one thing, implementation is another.
You need an inventory software which allows you to set reorder points for all your products which aligns with your ABC inventory strategy.
Otherwise all that work will have gone to waste.
Seeing all of your orders in one place makes it a lot easier to react to the strategies that ABC inventory helps put in place.
With Katana Smart Manufacturing Software you can set your reorder points whilst also putting your sales and production together in one dashboard.
It’s an ideal way to put your ABC inventory into action because all your demand is right there in front of you – in absolute real time.
You can optimize your inventory whilst also putting your decisions into action from a single, easy to use dashboard.
Mr. Pareto would be proud.