ABC inventory classification

A method of classifying inventory items based on their contribution and value to the business objectives.

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ABC Inventory classification

ABC Inventory classification

Introduction
ABC classification is a method of classifying inventory items based on their contribution and value to
the business objectives.
It is a segmented approach that reflects an approach that not all inventory is of equal value or
contribution to the business and that it is not a good use of time to put effort into managing every
item in the same way but that a differentiated approach focussed on fewer items can leverage
business benefit.
It is a simple framework to help understand which items in your warehouse are the most important
and therefore should consume most critical attention, management and control. Typically the
breakdown is as follows:
A items represent 10% of total inventory lines but are 70% of total annual value
B items represent 20% of total inventory lines but are 20% of total annual value
C items represent 70% of total inventory lines but are only 10% of total annual value.

Methodology
In the classic segmentation, all stock items (stock keeping units or SKU’s) should be ranked from high
to low based on:
Cost per unit x annual number of units used/sold = Annual consumption value
For example:

Item Cost $ per item Annual no. of items Annual Consumption

used/sold $ Value

Disinfectant 7.50 150 1,125

Paper towels 1.10 700 770

Cleaning cloths 0.40 1000 400

If the total annual consumption value for all business lines is £10,000, then
Disinfectant is 11.25% of total, Paper towels are 7.7% and cloths are 4% of total annual consumption.
Calculate the % of total annual consumption value and then divide the items into classes called A, B
and C. The A group represents the highest value items and will have approximately 20% of the
number of items but represent 80% of the total cost. The B, C groups each represent lower value
items but typically higher volumes of those items.
It is possible from the example above that items of over 10% of total annual consumption, such as
disinfectant, become A class, anything between 5-10% such as paper towels, becomes B class and
anything below 5% , such as cleaning cloths, becomes C class.

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This can be represented graphically by % of total value and % of total number of items.

This then determines your inventory policy. The items that constitute the higher value A group, will
be managed more closely than those with a lower value B and C groups.
Good practice management for higher value A class items should include:
• Counting stock more frequently to ensure accuracy and eliminate wastage
• Negotiating price and lead time more keenly with suppliers
• More rigorous reporting and accountability
B or C category items, with high volume of movement but low cost, such as the cleaning cloths,
would be managed less closely, counted less frequently, packaged less carefully, turned over less
often and reported more superficially.
C class items tend to cost very little but are consumed in high volume, such as fasteners, springs,
pens and pencils, cleaning cloths. However, C class items can also be expensive items that are rarely
used and the total annual consumption value is low.
Different service levels could also apply to each classification, such as re-order levels or safety stock.
The highest level of service are provided for the A items e.g. higher levels of safety stock; slightly
lower levels for the B products and lower still for C items. For example, 99% availability for A items,
97% availability for B items, 90% availability for C items.
Some methodologies include a group D too, to divide up and prioritise the typically long tail items.

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Careful implementation of inventory policy based on the ABC classification can result in reduced
inventory levels and therefore cost, improved customer responsiveness levels and better
deployment of the inventory skill set.
The cost of each item and the usage must be regularly reviewed to ensure that the right selection of
items is still be managed tightly and that the mix has not changed due to changes in production
portfolio or customer demand.

Pareto Principle or Rule of 80:20

Vilfredo Pareto (1848-1923) was an Italian industrialist, sociologist,

economist and philosopher. It was during his work with the Italian Railway
Company that he identified that 80% of the total wealth of Italy was held by
just 20% of the population and in 1909, when a lecturer in political
economics he published these observations. Thus was born the 80:20 rule.
It identifies the principle that roughly 80% of the effects come from 20% of
the causes and this holds true across a whole range of social and economic
life and more recently across the supply chain.

These initial findings were re-discovered by Joseph Juran (1904-2008)

during the 1940’s and named after Pareto. Juran characterized the 80:20
rule as ‘the vital few and the trivial many.’ He amended this in later years to
‘…the useful many’, to signal that the remaining 80%, although not vital,
should not be ignored.

Application of ABC classification

There are many different ways to apply ABC classification of stock within a business. The specific
criteria used in setting ABC levels and their importance to the business will vary by organisation.
These criteria can include annual sales revenue, profit margin, sales volume, customer service and
satisfaction. They may also reflect business priorities whether it be profit or product or customer
service or a combination of both.
In this way, ABC classification can be developed into a more sophisticated tool by varying the use of
the left hand axis to include other criteria such as perishability or profitability or customer fulfilment.
Whatever criteria is used the principle remains the same of focussing on ‘the vital few’.
ABC classification can be used in the case of items held for direct end customer use, such as in
Amazon style fulfilment centres which are prioritised by profit and customer service.

The classic Pareto curve can be divided into categories based on profitability and the contribution to
profit that each product at SKU level makes. The top 20% of products by profitability are the A
category; the next 50% or so are labelled B; and the final 30% are category C. The precise split
between the categories will vary from business to business and from market to market but it can be

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ABC Inventory classification

used as the driver for de-selecting unprofitable lines, negotiating price reductions in top profit lines
and directing marketing drives for those major profit generating lines.

Because the 80:20 rule can apply to customer service as well as products, the classification can be
used to differentiate stock holding policy. The profitable A items can be held as close as possible to
the customer and the B items further up the supply chain, thus offering better service for the in
demand A items with the slower moving B and C items being held further away in cheaper facilities.
The products that are highly profitable but only sell at a relatively slow rate are candidates for
centralized management and should be kept in a central location back up the supply chain in order
to reduce total inventory investment. They can be subsequently shipped by express transport direct
to customers when required.

This demonstrates how in its more sophisticated form, ABC classification can provide the basis for
developing a more cost effective service strategy, based on the ‘cost to serve’ the various different
classification of customers.

Professor Martin Christopher in Logistics and Supply Chain Management 5th edition
takes Pareto’s Principle to its ultimate conclusion:

“20% of customers buying 20% of the products = 4% of all transactions

Which provides:
80% of 80% of total profit = 64%
In other words, just 4% of transactions (measured order line by order line) gives us
64% of all our profit!

If the 80/20 rules apply to all products and all customers then all businesses are
actually very dependent upon a very few customers buying a very few high profit
lines. So the conclusion could be to offer the highest level of service and availability to
key customers ordering key products. And constantly review the less profitable
customers and the less profitable product lines.”

Whatever criteria is used the ABC principle remains the same of focussing on ‘the vital few’.
In this way, rather than being just a reporting tool, ABC inventory analysis and classification can be a
key tool to drive business strategy.

Case Studies
The use of ABC codes in inventory rationalisation
Taken from an article by Dr Muddassir Ahmed on http://www.scmdojo.com/inventory-
rationalization/

“I’m a big believer in the use of ABC codes, particularly for reporting. A primary requirement is that
the ABC codes have been assigned using a “proper” methodology. There are many ways to assign

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ABC codes and if done right, they should serve as a base for analysis, but I’ve seen many poorly
applied ABC code structures. The two most frequent improper applications that I have seen are
basing the ABC code of an item on the on-hand inventory value of an item rather than on demand
and using almost every letter in the alphabet for some sort of “intelligent” coding for the items. In
either case, the ABC code is basically useless for inventory rationalization analysis.
A starting point to use ABC codes is to generate summary reports by ABC. Typically this would be a
count of the number of items for the code, the sales over the reporting period, cost of sales/usage,
inventory on-hand, gross margin and inventory turnover for the category. With this information, you
can calculate GMROI (Gross Margin Return of Inventory Investment) for retailers,
wholesale/distributors and possibly finished goods for manufacturers.

When you do this analysis, you will like find that the A items have a relatively high turnover rate and
the C’s will tend to be low. What is interesting is that in many cases, a response to a directive to get
inventory down results in cutting A’s. Why? Because they are the most visible and easy to cut. This
can be done, but usually with disastrous results.
My experience is that A items have service issues and C items have turnover and excess inventory
issues. A items tend to be “self-liquidating”. By that I mean that if you stopped procuring the A
items (not that you would ever do that), the inventory will be consumed in reasonably short period
of time. The C items, on the other hand tend to have low turnover meaning that it will take a long
time to consume the inventory.
In many cases, I have advocated increasing the inventory for A items to improve service and then
start work on improving the performance of the C’s and the B’s. Even though this results in an
increased in A item inventory value, since the A’s should represent a small proportion of the total
inventory items, reduction of the value of C’s and B’s over time will result in a net reduction in total
inventory value and hence, an improvement in overall inventory turnover.

Savings at the tail end of inventory

Taken from an article by Dave Turbide in APICS Supply Chain management magazine 2018

A recent issue of APICS Supply Chain Management Now entitled “Technology leads to tail-spend
savings“, serves as a reminder of both the value and the shortcomings of ABC classification as we use
it in supply chain management today. As the article points out, we have been taught to divide items
to be managed into three groups — A, B and C — based on percentage of cost, annual dollar volume
or other criteria.

The tail spend referred to in the article is represented by those C items, which are great in number
but small in value. For example, if a company’s warehouse holds 1,000 different items cumulatively
worth $1 million, it’s likely that 200 A items have a value of $800,000. The next 200, the B items,
represent $100,000. The remaining 600 C items — which equal three times the number of B’s — also
account for $100,000.

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The study by McKinsey & Company referenced in APICS Supply Chain Management Now found that
companies can unlock significant savings — as much as 15 percent — by optimizing C items, despite
their low relative value. There are multiple reasons why this group of items holds such savings
potential. First, item cost and value don’t tell the whole story. A missing screw or bracket can halt
production or stop a shipment just as effectively as a missing circuit board or motor.

In addition, C items likely are the source of most excess and obsolete inventory. Because many C
items are low in volume and demand — and therefore are difficult to forecast — the tendency is to
stock more of them than is necessary, so Customer Service levels don’t sink. This seems like a
reasonable strategy, as the cost of C items is relatively low, but it also means these extra items are
being managed ineffectively. Maintaining extra quantities takes up valuable warehouse space, they
can get lost or damaged, and they all have to be cycle counted and insured. Additionally, because C
items are often ignored, people may not notice when demand declines or completely disappears. At
that point, the extra-large quantity on-hand becomes a complete waste.

Also, because most companies don’t manage their tail spend closely, their product data often is
scattered throughout their organizations in non-standardized formats. The authors found that, on
average, companies have only 20-40 percent of the needed data readily available. To help organize
data, companies can use text-mining tools and parsing algorithms to extract the data from local
databases, enterprise resources planning systems, purchase orders and other documents. In
addition, using heuristic rules to automatically convert units — for example from liters to kilograms
— can boost data quality by as much as 50 percent.

C items take a back seat when setting cycle count frequency, determining lot size and replenishment
triggers, and conducting general inventory management. But they should not be completely
overlooked. Certainly, focus on A items first and foremost, but once the A’s are firmly in-hand, the
job is not done. Instead, take the lessons learned from setting up processes and controls for A items,
and apply them to all inventory in order to unlock further savings and value.

Dave Turbide, CPIM-F, CIRM, CSCP, CMfgE, is a freelance writer and president of the APICS Granite
State Chapter, Certified in Production and Inventory Management and Certified Supply Chain
Professional master instructor.

Further reading
Martin Christopher – Logistics and Supply Chain Management 5th Edition

Dr. Muddassir Ahmed – www.scmdojo.com

APICS (American Production and Inventory Control Society) www.apics.org

Joseph Juran – The Quality Control Handbook 6th edition 2010

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Author
Susan has worked in corporate industry within procurement for many years,
undertaking everything from expediting, through contract negotiation, to
strategy development and large scale change management initiatives.
She is now focusing on project procurement, commercial training, coaching and
technical authoring through her own business.

Susan is a great contributor to CIPS and has been involved with CIPS through her
chairmanship of the Birmingham branch and participation in the annual
Negotiation Challenge events.

Susan Randall (BA FCIPS Chartered)

LinkedIn

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