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The inventory advisor

Oct 12, 2015

The ABC’s of inventory classification

It is difficult to view hundreds, or even thousands, of inventory items every day and make an informed decision on what to buy, what’s running short and what you have too much of. The best way to get to the most important items is by classifying your items.

Classifying your items allows you to focus on the 10-20% of items that will give you 80% of your sales.

The purpose of classification

  • To provide focus on the items that are most important to achieving your business objectives
  • To apply key policy parameters including target fulfillment rate and safety stock according to the role an item plays in the business
  • To identify those items that have not sold in a long time and should be made “Obsolete”, never to be ordered again
  • To identify those items that have not sold in the short-term and should be made “Non-stocked”, only to be ordered when a customer places a firm order
  • To improve productivity in the management of inventory so that you have the time available for the items that will give you the biggest benefit yet we do not totally ignore those items that need attention of a different kind

Symptoms of poor classification

The following are symptoms of poor classification:

  • Items that should not be ordered are triggering orders
  • The quantities being recommended are often completely incorrect
  • It takes far too long to get through the whole inventory management process
  • It is simply impossible to review all the recommended order quantities prior to placing orders and often items that should not be ordered are being ordered, resulting in excess stock
  • Applying the same target fulfillment rate and safety stock to all items does not use vital working capital effectively
  • Applying the required policy parameters (target fulfillment rate and safety stock) to items individually is far too much work, impossible to keep up to date and a more effective mechanism is required

How to classify

Applying the following steps in sequence will generally give you the best results with the least amount of effort:

  • Remove the noise, using criteria suitable to your business
  • Identify “obsolete” items, typically those that have not sold in 18 months to 2 years
  • Identify “non—stocked” items, typically slow movers that you will only ever purchase once you receive an order from your customer
  • Classify your items that move regularly (your “stocked” items) by ABC
    • Determine the annual usage/sales value for each item
    • Determine the percentage of the total usage/sales by item
    • Rank the items from highest to lowest percentage
    • Classify the items into A, B or C using cut-offs based on cumulative percentage

    Note: for manufacturing businesses it is important to include usage in your classification of stocked items, so that all raw material components do not end up as C items.

    The problem with this approach

    Items that are very cheap but sell thousands of units per month may end up being flagged as a C item in a value-based calculation. However, these items are very important to your customers who buy them.

    The answer is to apply exactly the same approach as above but based on unit sales. Now, instead of A, B or C you can compute high, medium or low velocity. This velocity classification becomes incredibly powerful when we combine it with the ABC classification we computed above.

    More appropriate inventory policy

    Now you can hone in on your fast moving cheap items, your slow moving expensive items and your “bread and butter” lines that are massively important to your business.

    Using this unique double classification to set inventory policy for each category will result in more appropriate inventory levels and a better allocation of working capital to your inventory investments.