9.5 Tools: ABC Classification of Inventories

Most companies manage inventory for a large number of products. In retail, the number can be overwhelming. Walmart.com, for example, manages over 1 million different products (also called stock keeping units or SKUs). A typical Wal-Mart supercenter carries around 142,000 SKUs. 1 If you're thinking, "Wow, that's a lot of SKUs. But, they can't all be equally important"—you're right. Retail consulting firm Willard Bishop found that 46% of all SKUs account for 95% of sales in a typical grocery store. On the slow selling side, 56% of SKUs sold an average of less than one unit per week per store. 2 The question is, "Where do you want to focus your inventory management efforts?"

uses the to help you prioritize your efforts (see Figure 9-2). Also called the 80/20 rule, the Pareto principle observes that 80% of costs are driven by your most important 20% of stock keeping units (SKUs). Most companies classify SKUs based on total costs, which are calculated by multiplying annual demand by cost per unit (annual demand X cost/unit). Why, you ask? Because the data is readily available. Strategic SKUs—the most important 5-10% of SKUs—make up a huge share of your total inventory costs (and probably firm profits). You classify them as "A" SKUs. You label the next 15-30% of high-usage/high-dollar-value SKUs as "B" SKUs. You label the remaining SKUs—the slow movers—as "C" SKUs. "ABC" classification is typically a two-step process.

Figure 9-2: ABC Classification applied to Inventory

Step 1: Classify SKUs by Costs- Build a SKU spreadsheet to calculate total costs/usage. That is, multiply annual demand by cost. Sort your SKUs by rank order. Then, classify the SKUs by looking for natural breaks in the cost analysis.

Step 2: Modify classifications based on strategic issues- Cost numbers tell only part of the story. You therefore need to consider other issues that might make a SKU more or less important. For example:

  • A SKU might be a new product launch. If you don't have the product, future sales might be jeopardized.

  • A specific SKU may be critical to other sales. In other words, if you don't have it available for sale, other sales drop off as well.

Step 2 requires experience, judgement, and good scanning skills to identify and accurately assess the right qualitative issues.

Once you classify SKUs, you need to establish appropriate inventory policies. In other words, you want to answer three questions:

  • Review: How frequently are you going to monitor each SKU?

  • Replenishments: How large and frequent should your orders be?

  • Safety Stock: How much safety stock do you need to protect against uncertainty and risk?

Figure 9-3 shares some basic guidelines for inventory policies. You monitor "A" items continuously. You make every effort to keep these SKUs in stock without carrying too much safety stock. By contrast, you check "C" items only periodically. Because your review cycle is longer, on a percentage basis you carry larger levels of buffer stock to mitigate the risk of stockouts. Let's now focus our discussion on tools to help you manage "A" items.

Figure 9-3: Inventory Policies for ABC Inventory Classifications

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