The “ABC” of Inventory Management

A blog post by Preeti Havaldar

The Pareto principle (also known as the 80-20 rule) states that – 80% of the effects come from 20% of the causes. This rule can be applied for product sales as well. As per studies, 80% of a company’s sales come from 20% of its products. From an inventory management standpoint, it is important for a company to maintain inventory for these popular 20% of the products that account for the most sales.

ABC Analysis

ABC analysis is the inventory control technique that builds up on the Pareto’s principle. It involves dividing the products in 3 categories – “A”, “B” and “C”, where category A contains most popular or profitable 20% of the products and category B and C contain the rest (can be divided as per the company’s preferences). While using ABC analysis, the company should focus more on managing inventory for category-A products to ensure they fulfill the demand.

The A-B-C classification

Many successful businesses use the ABC inventory management principle to classify products in order to stock them up for prompt sales. Let us look at how General Electric classifies its products into categories. The first attempt at classification was made by H. Ford Dickey in 1951, when Ford suggested that category of a product should be based on sales volume, lead-time and cash flow. Category A would include items with largest sales and longest lead time and category C would include items with low sales.

Suggested policy guidelines for A , B & C classes of items
Category A	Category B	Category C
Very strict cons. control	Moderate control	Loose control
No or very low safety stock	Low safety stock	High safety stock
Phased delivery (Weekly)	Once in three months	Once in 6 months
Weekly control report	Monthly control report	Quarterly report
Maximum follow up	Periodic follow up	Exceptional
As many sources as possible	Two or more reliable	Two reliable
Accurate forecasts	Estimates on past data	Rough estimate
Central purchasing /storage	Combination purchasing	Decentralised
Max.efforts to control LT	Moderate	Min.clerical efforts
To be handled by Sr.officers	Middle level	Can be delegated

ABC inventory management

The ABC classification also allows the company to apply different management techniques depending on the categories. For instance, the A-inventory should be counted regularly counted to ensure availability whereas C-inventory can be counted less often as it has items of lower importance. Also most of the storage costs should be used for A-inventory, whereas the least selling items from C-inventory can be removed to reduce storage overhead.

Role of demand forecasting in inventory management

Demand forecasting techniques can provide powerful insights to predict the demand for products and the products can be reclassified based on the forecast. For instance, if in a retail store, a torch is classified as category C today, in case of emergency, the torch can be reclassified as category A as the sales would spike up suddenly.

Inventory management is a crucial part of any supply chain as it accounts for internal costs to the company. Hence planning inventory is the most important phase of supply chain. Information systems and software can be leveraged to achieve inventory management efficiency.

http://yourbusiness.azcentral.com/role-paretos-law-inventory-control-techniques-10838.html

http://usabilityfriction.com/2010/04/14/the-8020-rule/  

http://logistics.about.com/od/forsmallbusinesses/a/Inventory-Classification.htm

http://www.materialsmanagement.info/inventory/abc-inventory-analysis.htm