ABC Classification: How to Manage Your Inventory for Maximum Profitability

By?Rafael Vela?/ March 16, 2023

Inventory management is a crucial aspect of supply chain management. It helps to maintain a balance between supply and demand, reduces costs, and ensures customer satisfaction. One of the techniques used in inventory management is ABC classification. In this article, we will discuss what ABC classification is and how to implement it.

What is ABC classification?

ABC classification is a technique used to categorize inventory into three categories based on their value. The technique uses the Pareto principle or the 80/20 rule, which states that 80% of the effects come from 20% of the causes. In inventory management, this means that 80% of the inventory value comes from 20% of the SKUs (stock keeping units). ABC classification helps in identifying high-value items and managing them effectively.

The ABC classification is based on the value of the inventory items, which can be determined using one of the following methods:

1. Annual consumption value: This method calculates the value of inventory items based on their annual usage multiplied by their unit cost.
2. Unit cost: This method calculates the value of inventory items based on their unit cost.
3. Margin contribution: This method calculates the value of inventory items based on their contribution to the profit margin.

Once the value of the inventory items has been determined, they are categorized into three groups:

1. A category: This category includes high-value items that contribute to the majority of the revenue. Typically, these items constitute 70-80% of the inventory value and 10-20% of the SKUs.
2. B category: This category includes medium-value items that contribute to a moderate amount of revenue. Typically, these items constitute 15-25% of the inventory value and 30-40% of the SKUs.
3. C category: This category includes low-value items that contribute to a minimal amount of revenue, in other words, everything that is left after determining A and B categories. Typically, these items constitute 5-10% of the inventory value and 50-60% of the SKUs.

How to do ABC classification?

To implement ABC classification, follow these steps:

1. Determine the value of the inventory items using one of the methods mentioned above.
2. Sort the items in descending order of their value.
3. Calculate the cumulative value and percentage for each item.
4. Calculate the cumulative percentage for each item and mark the point at which it reaches 80% of the total value.
5. The items up to this point are classified as A category items. The items between this point and 95% of the total value are classified as B category items. The remaining items are classified as C category items.
6. Review the classification periodically to ensure that it is still accurate.

Once categorized it is necessary to establish the management process for each group of products. In my long experience managing different types of inventory for organizations operating in different environments and industries I have always used the following parameters for managing each category and I recommend their use:

A Category:

1. Regular counting: High-value items should be counted frequently to ensure that they are always in stock and that there are no discrepancies in the inventory. You probably want to count these SKUs monthly.
2. Tight inventory control: A tight inventory control system should be implemented to prevent theft or loss of high-value items. This may include constant video surveillance, a dedicated storage area with tight access control, etc.
3. Safety stock: Safety stock should be maintained for A category items to ensure that they are always available when needed. The level of this safety stock depends on the vendor′s lead time, product value, usage, etc.
4. Automated replenishment: Automated replenishment systems can be used to ensure that A category items are always in stock and that the supply chain is not disrupted.

B Category:

1. Moderate counting: Medium-value items should be counted regularly but not as frequently as high-value items. You may be OK just counting this category every three months.
2. Moderate inventory control: A moderate inventory control system should be implemented for B category items to prevent theft or loss.
3. Safety stock: Safety stock should be maintained for B category items to ensure that they are available when needed, but the level of safety stock can be lower than that of A category items.
4. Automated replenishment: Automated replenishment systems can be used for B category items to ensure that they are in stock and that the supply chain is not disrupted.

C Category:

1. Infrequent counting: Low-value items can be counted less frequently than high-value and medium-value items. Counting every six months or once a year may be more than enough for this category.
2. Minimal inventory control: A minimal inventory control system can be implemented for C category items, as the risk of theft or loss is low.
3. Minimal safety stock: Safety stock for C category items can be minimal or not required at all, as the demand for these items is low.
4. Automated replenishment: Automated replenishment systems may not be necessary for C category items, as they may not be critical to the supply chain.

In summary, the inventory control and counting recommendations for each category depend on their value and importance to the business. High-value items should be counted more frequently and have a tighter inventory control system, while low-value items can be counted less frequently and have minimal inventory control and safety stock. Automated replenishment systems can be used for all categories to ensure that the supply chain is not disrupted.

Using the same level of control for all items is counterproductive, it is not being methodical or careful, and it is a mismanagement of resources. ABC gives you a map that clearly shows how to allocate resources to have an effective inventory management operation.

Best Practices for an effective ABC classification Strategy

As usual, here′s my recommendation for best practices to ensure an efficient and value-adding ABC classification strategy:

1. Regularly review and update the classification criteria: The classification criteria for ABC inventory should be regularly reviewed and updated to ensure that it reflects the latest business needs, changes in demand patterns, and market trends.
2. Use accurate data: Accurate data is crucial for the success of ABC inventory classification. Ensure that the data used to classify inventory is up-to-date, accurate, and complete.
3. Analyze inventory turnover: Analyze the turnover rate of inventory regularly to identify items that have high turnover rates and those that have low turnover rates. This will help you determine which items should be classified as A, B, or C.
4. Use multiple classification parameters: Using multiple parameters, such as value, demand, and lead time, will help you achieve a more accurate and comprehensive classification of inventory.
5. Assign responsible personnel: Assign responsible personnel to monitor and manage inventory classification. This will ensure that the classification is done accurately and on time.
6. Review classification results regularly: Regularly review the classification results to ensure that they reflect the current inventory status and identify any changes that need to be made.
7. Regularly perform inventory counts: Regular inventory counts will help you identify any discrepancies in inventory levels and ensure that inventory classification remains accurate.
8. Automate inventory management: Automating inventory management will help you achieve a more accurate and efficient ABC inventory classification strategy, as it reduces the risk of human error and streamlines the process.

By following these best practices, you can maintain a healthy and accurate ABC inventory classification strategy that meets the needs of your business and helps you achieve optimal inventory management.

Benefits of ABC classification

ABC classification has several benefits, such as:

1. Effective inventory management: By identifying high-value items, the inventory can be managed more effectively, which can lead to better utilization of resources and reduced costs.
2. Improved customer service: By focusing on high-value items, the supply chain can ensure that these items are always in stock, which can lead to improved customer service.
3. Better decision-making: By understanding the value of the inventory items, the supply chain can make better decisions on when to order, how much to order, and when to replenish.

The main idea behind ABC classification is that NOT ALL INVENTORY ITEMS DESERVE THE SAME LEVEL OF ATTENTION AND CONTROL. Giving the same attention and control to ALL products in your inventory is inventory mismanagement. Not all products have the same value or importance to the organization and control measures must be based on that level of importance.

ABC classification is a simple but effective technique for inventory management.

By implementing ABC classification, the supply chain can reduce costs, improve customer service, and make better decisions.

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