Dec 01, 2016
The five advantages of an effective ABC analysis [Updated]
In the land of inventory, not all things are equal, and each stock item behaves differently. Determining the difference and classifying these accordingly is the starting point of any successful inventory management system. Let's first define what an ABC analysis is.
The ABC analysis is a criterion that is based on the Pareto principle - the 80/20 rule whereby 20% of your items give you 80% of your sales. A = highest value, B = medium value and C = least value. However, using this analysis in isolation has its downfalls. A high-value, low volume item like a car engine is planned and managed in your inventory system far different from that of a low-value, high volume items like nuts and bolts, even if the annual turnover is the same.
Overlaying this with another set of criteria, for example, the sales velocity of each item where H = high, M= medium, and L - low, will make your classifications that much more precise. In essence, an AH item is a high-value, high-velocity item. In contrast, a CL item is a low-value, low-velocity item.
The top 5 Benefits of effective classification
1) Fight fewer fires
You need to choose your battles in business as you do in life.
When it comes to managing your inventory, you cannot fight every fire that pops up every day, so how do you choose which battles you want to take on? Classifying your inventory allows you to do just that. Since they are in groups, you can stop wasting your time on the unimportant ones. Spend your time and energy on the items that make a difference to your business - the ones that bring you the turnover - your AH items. "A" category products usually make up 20% of revenue but even a lower percentage of the inventory investment. Intersect this with the high volume items only, and it drops even lower to perhaps 5-10% of the products. That is a fire you can fight, but even more important, that is a fire worth fighting!
2) Invest working capital on products that deliver sales
Inventory management would be easy if we had infinite working capital to work with. You could stock as much inventory as was needed to get a 100% fill rate on all items.
But in the real world, that's just a pipe dream. You have real working capital constraints that must be taken into account. Deploying that working capital properly can make the difference between mediocre sales and shooting the lights out.
By now, you've probably guessed that you can use your ABC & HML analysis to achieve this. Looking back at the Matrix, it's easy to see that there's no point investing huge amounts of capital into the CL items: they don't contribute much to the bottom line. Centralize those CL items in a Distribution Center if you need to have them available rather than keeping them in multi-locations for "just in case”. Instead, invest most of your working capital into the AH items. Not only will they make a lot of sales and profit, but they also move quickly, turning your money over faster.
3) Manage important items more closely
If you have an item flagged as a Potential Stock-out, depending on its classification, your reaction will be very different. CL items can basically be ignored, at least until a later time. AH, items, on the other hand, should be managed immediately.
The opposite is also true. When an item gets flagged as having Surplus Purchase Orders, you will respond in one of two ways, depending on the classification. CL items must be managed immediately. Cancel the order if you can, because those extra items will sit in your warehouse for a long time, and won't make any profit when they are eventually sold.
However, if you ordered too much of a High-Velocity item, it may not be a massive problem as those items move quickly. You should only worry about these items if you ordered a few months' worth of extra units. But an extra week or two of High-Velocity items won't really matter.
4) Let an automated system manage less important items automatically
If you get the forecast wrong by 20% on an AH item, it's a huge deal. But there are probably thousands of items where a 20% forecast error is not even a blip on the radar screen.
Let an automated forecast engine take care of those items for you. Spend your precious time on the items that matter.
You are guaranteed to increase profit if you invest your working capital, time, and energy into the items that give you the highest return on investment.
For many companies, the lack of inventory classification makes the challenge of managing inventory effectively almost impossible. If your planning team is always busy but never seems to get there, this indicates a lack of the focus that item classification can bring. Remember that if everything is important, then nothing is important!
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Written by Barry Kukkuk
Barry comes from a systems architect and application development background. He started his career as the co-founder and chief developer for Icon Retail Management, a full-fledged retail management system that integrated with mainstream ERP. Barry later conceptualized and developed Inventory Optimiza for Barloworld Logistics and provided technical support for the application. It was here where Barry’s passion for Inventory Management solutions began and the industry where he would later return. Barry went on to start his own business in 2008, where he was an avid user of cloud-based apps and would only use online solutions for his business. In 2010 Barry began his journey with NETSTOCK. His enthusiasm for Inventory Management and his strong belief in “all things Cloud” collided, and we saw the release of the Inventory Management solution - NETSTOCK. Barry is the CTO at NETSTOCK, where he is responsible for all customer-facing technologies and systems that keep thousands of NETSTOCK customer instances working correctly.