5 essential steps to make more strategic assortment decisions
The life of someone who works in the supply chain is never easy. Therefore, it is vital that you focus on the right things.
But what are these “right things”? Which products should be the main focus of your attention?
Before we delve into the topic of ABC Analysis, imagine that you have a range of 10,000 Stock Keeping Units (SKUs), over 1,000 customers and hundreds of suppliers. For each of these SKUs, you will need to determine an inventory strategy.
To begin with, you should ask yourself:
When should I order?
How many should I order?
What service level should I assign to each item?
But, as you will see, there are many more questions …
25% of your items do nothing!
According to the classic Pareto analysis, 50% of your products create just 5% of your total margin. Of course, this is still 5% and cannot be ignored. But should we give these items the same focus, investment and importance as the top items that really make us money?
What if we delve a bit deeper? A completely different picture starts to emerge.
In this article, we will explore how you can identify your most important items to implement more effective inventory strategies.
But first, let me explain the laws of Pareto and how they work in practice.
What is ABC Analysis?
To apply the laws of Pareto to the supply chain, we often use a clever technique called ABC Analysis. In essence, ABC inventory analysis is the process of classifying inventory by priority, based on given criteria. With the insights that this analytical approach provides, we can identify meaningful opportunities to optimise inventory levels.
This useful tool helps supply chain teams to reduce carrying cost and unlock working capital. But more importantly, a good ABC analysis should help increase sales turnover through attaining better availability on the products that matter most to the customer. As a result, businesses that take advantage of this approach run leaner and more efficiently.
When you’ve finished, your inventory will typically be divided into three core categories – A, B and C – based on strategic importance.
Category A: Products which are important and thus require tight control.
Category B: Products which are of lower importance, but even so, must be managed with a medium level of control.
Category C: Products which are of lower importance and which only require the simplest level of control.
The name “ABC” suggests that you have just 3 classes. But if you wanted, you could distinguish 10 classes. However, this could make the data a little trickier to interpret. We will explore this later.
The Pareto principle, also known as the 80/20 rule, indicates that 80% of a company’s turnover is generated by only 20% of the assortment. These are the ‘golden eggs’ and should be treated with care and attention.
In the following example, Category A articles contribute 70% to the company’s margin, Category B articles contribute 20%, and finally Category C articles contribute 10%.
The graph below clearly shows that 70% of the articles only contribute 10% to the company’s margin. Often these Category C articles require a lot of consideration because of their volatility and the complexities around properly forecasting their future demand.
However, given that the Category A articles are the most important items to the business, they should receive proper focus and should not be neglected.
Why is it important to classify your products?
When you offer a large assortment, it is easy to get distracted by products that offer a very low contribution to your company’s profit margin. The main reason is the fact that these items often show a high volatility and are therefore difficult to manage.
The whole purpose of ABC Analysis is to logically structure your assortment and identify your priorities within it. As a result, you should benefit from greater focus. By classifying products based on their strategic importance to your business, you can ensure that you invest your time and money where it counts most.
Why should you do an ABC Analysis?
ABC analysis will provide you with a great deal of interesting insight into your assortment. This can be used to drive optimisation initiatives that are designed to save money, improve service and boost profitability.
Here are just a few examples of how your business could benefit from completing an ABC analysis:
Changing your investment priorities to focus on Category A items, as opposed to Category C items which are not doing much for the business
Implementing new strategies that minimise the requirement for manual intervention on unimportant products
Refocusing your team’s attention to proactively managing important products and preventing issues before they can impact the customer or the bottom line
Ultimately, you should use this handy analysis to spend time and resources, both of which are usually in short supply, on the things that really make a difference.
What steps are involved in an ABC Analysis?
ABC analysis can be performed on a wide selection of criteria, such as your historic or forecasted figures relating to:
Cost of Goods Sold (COGS)
The steps required to complete an ABC analysis depend on the level of complexity and detail you wish to explore.
But first, let’s consider your goals.
What is the aim of your ABC Analysis?
The first thing the management team must do is to determine what you wish to achieve by performing an ABC analysis.
Here are a few examples:
Is it to determine which products are important?
Is it to determine which customers are important?
Is it to determine what the warehouse layout should be?
The objective we are aiming for will form the basis of the ABC analysis.
Should the management team want to attain a better understanding of your assortment (#1 above), then ideally the following data will be needed:
Margin per SKU
Number of customers per SKU
However, should the objective be associated with warehouse layout (#3 above), then the following data will be key:
Number of picks per SKU
Metres squared (or cubed) per SKU
What kind of ABC Analysis is right for your business?
Now that you have determined the goals of the analysis, how complicated does your analysis need to be to achieve the desired insight?
Are you looking for a simple ABC analysis based on just one criterion? Or do you need a more detailed ABC analysis that looks at multiple factors?
For a quick and easy result that everyone can understand, it probably makes sense to go with a simple analysis. However, if you need a more granular breakdown of your assortment, you will need to dive a bit deeper.
Completing a simple ABC Analysis
Are you setting up a new warehouse and would like to know what your fast runners are so that these items can be stored in easy access locations? (Probably low down and near the front of the warehouse.) Then a simple ABC analysis identifying the number of order lines or sales turnover would suffice.
To complete this single-dimensional ABC analysis, we simply take the most important criteria and categorise the products based on the extent to which each of them contributes to the business.
More complex, multi-dimensional ABC Analysis
If your business is interested in identifying the items that also make the most money in order to help the planning team to prioritise these products, we need a multi-dimensional ABC. Sometimes, this is referred to as ABC-XYZ analysis.
For this example, we could use:
Dimension 1 = Margin
Dimension 2 = The Number of Order Lines or perhaps Sales Volume
By looking at two different dimensions we can gain a much richer insight into how each item performs on the two factors in question. For example, if a product ranks low in terms of margin but high in terms of number of customer orders, we can see that this is a key product within our assortment.
What criteria should you base your ABC analysis on?
There are lots of criteria we could use to conduct an analysis. However, it’s important that you select the criteria which best fits the goals of your analysis.
Here are just a few examples of criteria you could use and what the analysis will tell you:
What does this data tell you?
Why is this important?
How much revenue does a particular product generate?
Identify which products sell in the highest volume
How much profit margin does a particular product generate after accounting for the cost of goods sold?
Identify which products generate profit for your business
How much margin does a product contribute after all costs have been considered?
Identify which items have the biggest impact on your bottom line
Is the product in question bought by just one customer or do many customers buy this product?
Understand your risk exposure. E.g. if there is only a small number of customers and one stopped buying from you, this would have a big impact on the overall demand
Is the demand made up of one big order or many small orders?
Understand how frequently and in what quantity each item is purchased
Ultimately, it is the management team who should determine which criteria are important as well as how many criteria should be used to complete the analysis.
How to perform an ABC Analysis
Now that you have determined whether you need a simple analysis or something more complex, and the management team have outlined the main criteria, the next step is to perform the analysis.
There are lots of slightly different approaches to undertake an ABC analysis. However, there are typically 5 main steps. To keep things simple, we will use margin as our main criteria in our worked ABC Analysis below.
1) Prepare your data
Before you begin your analysis, you will need the right data. To do this, extract the data with the selected criteria over the desired date range at an item level. In our example, we need to extract the margin of each SKU.
2) Sort your data
Now, take each ABC criteria in turn and sort your products from highest to lowest. In the ABC analysis example below, we have organised the data in descending order based on the margin each item offers.
3) Calculate the percentage each item contributes
Calculate the margin each item contributes as a percentage of the overall margin for the entire assortment. Then, starting with the product with the highest margin, calculate the accumulated margin as a percentage.
4) Categorise your items
Based on the accumulated percentages, classify your products into your ABC categories. Typically:
Category A items = those items representing the top 80% of your assortment
Category B items = those items representing the next 15% of your assortment
Category C items = the remaining items making up the final 5% of your assortment
In this example, the drilling machine and workbench have the highest impact on the company’s margin. We therefore class these as our Category A items. Making sure enough inventory is available to meet customer demand is very important for these items.
5) For a multi-dimensional analysis, repeat the process
In contrast to an ABC analysis, a multi-dimensional, or ABC-XYZ, analysis allows you to use multiple criteria to determine the importance of an article. To complete your ABC-XYZ analysis, repeat Steps 1-4 with the second criteria.
How should you interpret your results?
After completing the ABC analysis, each product should be classified as a Category A, B or C item. For multi-dimensional analysis, the results should look something like this:
In the example above, the ABC-XYZ analysis is based on margin and order lines. The so-called “AX” articles are the most important to the business, while the CZ articles are of low importance.
Based on the ABC-XYZ classification, companies are able to differentiate service levels per classification group. The service level of AX products could be higher than CZ products.
What else do you need to think about?
How many Category A items should you stock?
One key question that always gets raised is: “How many Category A items should a company have?”.
After all, these are the items that should have maximum focus and the most regular review (other than the new items). It makes sense, since these are the money makers.
If there were two planners, they would effectively be able to optimise the top 500 items (based on margin).
These 500 items account for 0.3% of the total items within the assortment;
Yet they account for 25% of the margin.
This kind of distribution is not unusual, and whilst the above focuses on Category A items, your planners still need to spend some of their time on Category B and Category C items.
However, as highlighted above, it should be the Category A items they should focus on.
How should you manage more complex products?
Creating the classification based on historical data means the sales have actually happened and the data is likely to be reliable. But what if you have seasonal items?
If there was a peak in demand in the past couple of months because of a heatwave, and you classify your products based on these particular months, your ice-creams will be classified as very important. However, these items will not be sold in these high quantities during the rest of the year. So how many months’ worth of data and when to perform the analysis exactly is of high importance.
Furthermore, supplier lead times should be taken into account. If the lead time of an inflatable swimming pool is 4 months, and you are making a classification in high season for the forthcoming 2 months, the swimming pool will of course be classified as very important, resulting in a higher service level and therefore more inventory.
But with a lead time of 4 months, the inflatable swimming pools will be delivered in the autumn.
Performing a dynamic ABC classification based on forecasted demand is often a great way to make sure seasonal products, or products which show a positive or negative trend, get the right service level and focus.
Products that are becoming increasingly popular can, at this point in time, still be a BY article. But based on the trend in sales, the forecast clearly indicates that the product will become a fast mover. Therefore, the item should have a higher service level and already get more attention to make sure inventory levels are increased to manage the upcoming demand. By dynamically recalculating the product classification, organisations can make sure items receive the right level of attention and have the best corresponding service level based on the demand.
Some final thoughts
In this article, we have explored the steps you need to take to complete an effective ABC analysis.
Hopefully, these simple tips will enable you to take action to maximise the value of your assortment and identify meaningful opportunities to reduce inventory levels.
But why stop there?
Find out how you can take assortment management to the next level with our simple guide to optimising your product range throughout every stage of the product lifecycle.
FAQs about ABC analysis
What is ABC analysis?
ABC analysis is a clever technique to help you manage your inventory. In essence, ABC analysis is the process of categorising items based on their value or importance to the business. The top items are categorised as Category A items. These are the most valuable or important, while the bottom items are categorised as Category C, which are the least valuable or important. This allows businesses to focus their attention and resources on the items that matter most
What are the benefits of ABC analysis?
ABC analysis is a quick and easy tool for inventory management. It offers several business benefits, including better resource allocation, improved decision-making and increased profitability.
What are the weaknesses of ABC analysis?
Although ABC analysis can be a powerful tool for inventory management, it’s important to recognise that it has some limitations. Here are a few potential weaknesses to keep in mind:
Lack of context
It is also important to bear in mind that clean data is key, and all staff should be made aware of the importance of this whenever they are entering data into the system.
How often should I conduct an ABC analysis?
The frequency with which you should conduct an ABC analysis depends on the nature of your business and the rate of change in your inventory. For example, if your business operates within a fast-moving environment, it makes sense to update your ABC analysis regularly. Ultimately, the goal is to ensure that your ABC analysis is conducted often enough to provide actionable insights, without it being so frequent that it becomes a burden on your resources.
What should be avoided in ABC analysis?
There are a few common mistakes to avoid:
1) Illogical parameters
If your parameters are misaligned with your business priorities, the resulting product categories will also be misaligned. Therefore, items may be at increased risk of being over- or under-stocked.
2) Not updating the classifications
An ABC analysis is not something you should do once and then forget about. The classification of items may change over time. Therefore, it’s important to review and update the ABC analysis on a regular basis to ensure that items are still categorised correctly.
3) Ignoring other factors
While ABC analysis is a useful tool, it is important to consider other factors, such as demand variability and lead times, as well as market intelligence.
4) Focusing only on Category A items
Category A items are typically the most important. However, this does not mean that other items should be disregarded. Other categories must also be managed carefully to ensure the optimal inventory level is achieved.